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Japanese banking crisis: Deregulation, weak corporate governance contributed to systemic problems

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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In the second half of the 1980s, Japan enjoyed above-trend economic growth and near-zero inflation. These conditions resulted in a significant decline in the country risk premium and a marked upward adjustment in growth expectations, which boosted asset price inflation fueled by credit expansion. At the time, Japanese banks were considered among the strongest in the world. During the same period, the pace of financial liberalization and deregulation accelerated, which spurred price competition and prompted banks and other depository institutions to take greater risks, including increased lending to the real estate industry. As land prices rose, these institutions loosened credit standards. In response, the authorities limited total bank lending to the real estate sector, curtailing the banks’ asset growth.

Asset prices peaked in 1989 and collapsed after the summer of 1990. Economic growth subsequently slowed and, along with the decline in stock and real estate prices, weakened banks and other financial institutions. By 1997, Japan was in the midst of a full-blown banking crisis. An IMF Working Paper by Akihiro Kanaya and David Woo, The Japanese Banking Crisis of the 1990s: Sources and Lessons, examines what went wrong and why it has taken the system so long to recover.

The Japanese banking crisis is a fitting subject for a case study, the authors say. First, most of its underlying causes are typical of banking crises in general. Second, it serves as a warning that even a seemingly robust and relatively sophisticated financial system like Japan’s is not immune to crisis. Third, it demonstrates that such a crisis can entail large costs for the country. In fact, according to Kanaya and Woo, a number of researchers attribute the stagnation of the Japanese economy in the 1990s in large part to the banking crisis.

What went wrong?

The working paper traces the problems in Japan’s banking system to the increased pace of deregulation and a deepening of the capital markets in the late 1980s, which overburdened the capacity of the system. Financial liberalization and deregulation took the form of a relaxation of interest rate controls; capital market deregulation, which included measures that made it easier for large corporations to borrow directly from the market; and a relaxation of restrictions on the activities of institutions that had previously been tightly segregated. For example, agricultural, fishery, and credit cooperatives were allowed to increase their lending to nonmembers.

These developments, Kanaya and Woo observe, had important implications for banks and other depository institutions. Price competition intensified, eating into the banks’ risk-adjusted interest rate margins. Banks reacted by taking on more risk, for example, extending the average maturity of their loans. To boost short-term profits, they loosened credit conditions.

The Japanese stock market peaked at the end of 1989. In April 1990, the authorities began to limit bank lending to the real estate sector in an effort to rein in land prices, which started to decline in 1992. As a result, Kanaya and Woo explain, the banks’ asset growth began to level off, declining from ¥508 trillion in 1989 to about ¥491 trillion in 1990. The collapse of asset prices in 1990 caused economic growth to slow, significantly weakening the banks and other financial institutions. The weakening was manifested in the rapid deterioration of the quality of loans to the real estate industry, erosion of the value of collateral, mounting pressure on bank capital, and a decline in debtors’ ability to continue servicing their loans.

Other developments that exerted pressure on banks, Kanaya and Woo observe, included their downgrading by credit-rating agencies, which began in 1989, and the gradual lifting of restrictions on Japanese corporations’ access to the domestic and euro bond markets, leading to an acceleration of new bond issues (see table, page 87). The downgrading of Japanese banks made it more attractive for larger Japanese corporations—which by 1989 had unrestricted access to the capital market—to raise funds in the capital market than to borrow from banks whose credit rating was lower than theirs. The restrictions on small and medium-sized companies in the domestic market were gradually removed during the 1990s.

Why recovery was slow

Although some banks took steps to reinforce credit standards and conditions following the collapse of asset prices, this effort did not go far enough to jumpstart the recovery. Kanaya and Woo attribute the seriousness of the banking crisis, in part, to weak corporate governance. The ownership structure of a typical Japanese bank gives relatively few shareholders the majority of total outstanding shares. This has given rise, the authors say, to a “largely ineffectual corporate governance system in which shareholders have only a modest control over the management of banks.” As a result, bank management is not pressured to maximize profitability, focusing instead on market share and on providing stable employment and services for clients. (Kanaya and Woo note that before interest rates were relaxed, Japanese banks derived most of their income from interest earnings, so that their outstanding loans largely determined the size of their net income. Banks’ preoccupation with market share is a legacy of this earlier system.)

Weak profitability, in turn, means that when loans go bad, banks do not have the retained earnings to deal with them and, moreover, have difficulty raising new capital in the market. In addition, with weak accountability, bank managers do not have the incentive to restructure and will not address problems during their tenure. Another feature of Japanese corporate governance, which Kanaya and Woo say had worked reasonably well until the 1990s, was a system in which lenders designated a main bank to act as monitor of the borrowing firm and mediator when borrowers experienced stress. The main banks were responsible for identifying problem borrowers before they became insolvent and for helping them restructure their businesses. Problems arose when the main banks themselves came under stress and, rather than allow their borrowers to default, treated them leniently despite their questionable long-term viability.

Authorities’ initial response

Between 1990 and 1995, Kanaya and Woo say, the authorities did little to address the deteriorating conditions in the banking system, partly because they held out hope that the economy would recover on its own and give the banks the boost they needed. Although the banks continued to deteriorate after 1995, the authorities were reluctant to intervene for fear of igniting a panic. Their reluctance, the authors explain, was compounded by the fact that Japan did not have an adequate deposit insurance scheme or a legal framework for dealing with a full scale banking crisis. This regulatory “forbearance” Kanaya and Woo note, created moral hazard problems and further weakened the banks. Depositors had begun to withdraw their funds from weakened financial institutions in 1995 but, following the failures of several major ones, increased their withdrawals in 1997.

When the authorities finally intervened, they did so only after the affected banks became insolvent, and their delay prolonged the crisis. With the effective bankruptcy in 1997 of several large, high-profile institutions, the Japanese authorities ordered these institutions to suspend their operations. Subsequently, the authorities introduced a framework for dealing with banking crises. It gave banks the responsibility for valuing their assets according to well-defined guidelines and then required external review and monitoring of these findings. A second component of the framework was designed to narrow the scope for regulatory forbearance by defining conditions under which regulators would have to take remedial action against banks.

By 1998, the public recognized that the problems were severe enough to require public funds to restructure the system. Although emergency laws were passed in February 1998 to stabilize the financial system, Kanaya and Woo say the banking supervisory authorities were still not fully equipped to deal with the magnitude of the problem.

New framework

In June 1998, the Financial Supervisory Agency was established to take over bank supervision from the ministry of finance and was granted the independence to operate more effectively. In October, the Diet passed two laws—the Financial Revitalization Law and the Financial Early Strengthening Law—to help resolve banking problems. The Financial Revitalization Committee, established to oversee the bank restructuring process, required banks seeking a capital injection to submit a restructuring plan, which would be subject to review. At the same time, the Diet doubled the amount of funds earmarked for strengthening the banking sector, which made available ¥60 trillion (12 percent of GDP)—¥25 trillion to recapitalize weak but solvent banks, ¥18 trillion to nationalize or liquidate insolvent banks, and ¥17 trillion to fully protect the deposits of insolvent banks.

Although bank closures or suspensions continued during 1998, Kanaya and Woo say that the Japanese banking sector appears, for the time being, to have stabilized. They emphasize, however, that the sector’s long-term health is still contingent on the banks’ ability to restructure, which will entail tackling still sizable problems with the quality of assets, dealing with weak corporate profitability, and strengthening corporate governance.

Credit rating of Japanese city banks
Bank of Tokyo-MitsubishiDai-Ichi Dangyo BankFuji BankSakura BankSanwaSumitomoBankTokaiBank
1980BA/BBA/BB
1981BA/BBA/BB
1982B/CA/BBA/BB
1983A/BA/BB
1984BBA/BA/BB
1985A/BB/C
1986BBBBB/C
1987C
1988BBBBB/C
1989B/C
1990BBB/CBBB/C
1991B/CBBB/C
1992B/CB/CB/CB/CB/CB/C
1993B/CB/C
1994B/CB/CCB/CB/CB/C
1995C/DB/CB/CC
1996B/CCCDCCC/D
1997B/CC/DDCCC/D
1998CDDDC/DC/DD
1999C/DDDDDC/DD
Data: IMF, The Japanese Banking Crisis of the 1990s: Sources and Lessons
Data: IMF, The Japanese Banking Crisis of the 1990s: Sources and Lessons

The authors describe three recent developments that—if they become a trend—bode well for the future of the Japanese banking system: voluntary mergers; approval of a foreign acquisition of a major Japanese bank, which would reinforce the introduction of modern banking practices in Japan; and a planned merger between two banks that belong to two competing industrial groups, which has implications for economy-wide restructuring in Japan.

Lessons of the Japanese crisis

Kanaya and Woo conclude by drawing a number of lessons from Japan’s banking crisis.

  • In a financial system already characterized by overcapacity—like Japan’s—deregulation can lead to excessive competition and risk taking. This problem is especially acute when unprofitable institutions are not subject to market forces.

  • If deregulation is not coordinated and properly sequenced, it can be particularly harmful. “Regulatory arbitrage,” for example, resulting from unequal regulatory and supervisory treatment of different financial institutions involved in similar activities, can lead to unhealthy competition and concentration of risk.

  • Given the serious consequences for the financial system of property cycles and asset bubbles, banks must base lending decisions on cash-flow analyses of their borrowers and must reassess their creditworthi-ness in a timely manner.

  • The Japanese main bank system relies excessively on the role of the main banks to monitor borrowers. If the main banks are themselves distressed, they may delay dealing with troubled borrowers, thereby worsening the problem.

  • Weak corporate governance can prevent banks from restructuring to arrest their deterioration.

  • Transparent accounting standards are important for effective supervision of financial institutions.

  • Regulatory authorities must take a proactive approach toward supervision. If they exercise forbearance, they can postpone a crisis but will raise the fiscal cost of the final resolution.

Copies of IMF Working Paper 00/7, The Japanese Banking Crisis of the 1990s: Sources and Lessons, by Akihiro Kanaya and David Woo, are available for $7.00 each from IMF Publication Services. See page 94 for ordering information.

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