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Japan’s financial system assessment: Removing bad loans will be a crucial first step in restoring health to banking sector

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
October 2003
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IMF Survey: Japan has had a troubled financial sector, and economic growth has been low. Can’t the banking sector’s problems be dealt with simply by revitalizing the economy?

Ingves: In my experience, if banks wait for the economy to solve their problems, they may never work themselves out of their difficulties. It is better to acknowledge that things didn’t go well and really work on the solution. This means, at the level of individual banks, dealing with bad loans one by one.

IMF Survey: Japan’s economy has some fairly unusual characteristics—zero interest rates, for example—that must have played a part in your findings. Ingves: Japan’s financial sector is dominated by banks and heavily influenced by the public sector, with several very large government-owned financial institutions. The basic structure is not unlike that established in many industrial countries after World War II. But this structure remained in place longer in Japan than in most industrial countries. Then the country experienced a bubble, followed by low or negative growth. That created a special environment. The lower the growth in the economy, the harder it is to deal with the problems in the banking sector. In any country where the economy is shrinking, non-performing loans can become a problem.

What is unique in Japan is that nominal interest rates are very low. These low rates are necessary to counter deflation and preserve financial stability. As a side effect, they may make it more difficult to determine bad loans because weak borrowers, whose repayment capacity is in doubt, can keep servicing their debt. What we saw when we did our assessment was a financial structure that now has to generate structural change in a difficult environment.

Financial Sector Assessment Program

Resilient, well-regulated financial systems are essential for macroeconomic and financial stability in a world of increased capital flows. The Financial Sector Assessment Program (FSAP), a joint IMF and World Bank effort introduced in May 1999, aims to increase the effectiveness of efforts to promote the soundness of financial systems in member countries. Supported by experts from a range of national agencies and standard-setting bodies, these assessments seek to identify the strengths and vulnerabilities of a country’s financial system; determine how key sources of risk are being managed; ascertain the sector’s developmental needs; and help prioritize policy responses. Detailed assessments of the observance of relevant financial sector standards and codes are a key component of the FSAP.

The FSAP forms the basis of Financial System Stability Assessments (FSSAs), in which IMF staff address issues of relevance to the organization’s surveillance, including risks to macroeconomic stability stemming from the financial sector and the capacity of the sector to absorb macro-economic shocks. The FSSAs are discussed during the Article IV consultations with member countries. To date, FSSAs have been finalized for about 60 member countries, including major industrial countries such as Canada, Switzerland, the United Kingdom, and, recently, Japan. While the publication of the FSSA is voluntary, over 30 countries have chosen to publish their FSSAs, which are available on the IMF’s website (http://www.imf.org).

IMF Survey: In terms of Japan’s banking sector, then, were you in uncharted waters?

Ingves: When you are talking about how to deal with banks in trouble, the toolbox available is familiar. These techniques have been tried in many countries all over the world. They work in countries where the government can still finance support of the financial sector, which is the case of Japan.

IMF Survey: Was there anything in the course of Japan’s FSAP that surprised you?

Ingves: There is always something that you did not entirely anticipate. In Japan, we discovered that the insurance supervisor had practically no actuaries on its staff. This is one of the largest insurance sectors in the world. We discussed this with the authorities, and now they have hired more actuaries. It’s nice to see these details resolved. That is an important part of the FSAP process.

IMF Survey: Your report divides its recommendations into stock and flow issues. Could you elaborate?

Ingves: In the short term, the chief problem in Japan’s financial sector is that its banks have very little capital. If a banking sector is undercapitalized, it is not going to be too keen to lend; it will be preoccupied with its own problems and vulnerable to negative economic and market developments. Now, this is compensated for, in Japan, by a very well developed safety net, which articulates in detail what the government and the Bank of Japan are expected to do when a bank runs into trouble. It has been used and lends stability to the system.

What you need to do to deal with Japan’s stock problem, then, is to move nonperforming loans out of the banks and recapitalize the banks. And when you recapitalize, you must ensure there is proper governance. It’s not enough to just put in the money and hope the problem will go away.

But the problem is not only nonperforming loans. Japanese banks have—and have had for a long time—low profitability. You can increase profitability by producing new types of banking services, but in Japan, profitability is also linked to the large role of the government in the financial sector.

Today, Japan’s Postal Savings System and Postal Insurance System are among the largest such systems in the world. They have actually grown in recent decades. Almost every Japanese has an account with the Japan Post, and many also have a life insurance policy with the system. Money in these systems is largely channeled to the government, because they invest mostly in government bonds in one form or another. These systems have also, in the past, offered favorable conditions to depositors, been subject to limited prudential supervision, and been largely exempt from taxation. This has put them in a favorable situation when it comes to competition.

Add to this a number of other types of government-funded schemes for housing and for lending to small and medium-sized enterprises, and you have a government that competes with the private sector. It is not a fully level playing field. If the government maintains its current role in the private sector, the banks are likely to continue to have problems with their profitability. The government then ends up having to put money into the banks that it doesn’t allow to make sufficient money in the first place. That’s not a sustainable situation.

IMF Survey: What steps need to be taken then?

INGVES: The report takes the stand that the bigger, publicly supported lending schemes and deposit-taking institutions need to shrink their involvement in the financial sector if Japan’s banking sector is to increase its profitability, consolidate, and develop new and better products. But, given the millions of people involved, the shrinking has to happen in an orderly way. It seems anomalous, but in the short run, the government needs to get more involved in dealing forcefully with the banking problems and the lack of capital, whereas in the medium term, it needs to reduce its role in the financial sector. How do you square that circle? Well, the issue here is timing.

IMF Survey: Are you optimistic that Japan will accelerate the pace of its reforms, as the FSAP suggests is needed?

INGVES: We very much want to see Japan accelerate its reforms. These problems have been lingering for the past 10 years. In a technical sense, this is not rocket science. The methods you use to generate change are well known and well tested. At this point, it’s more a question of how to get the process going, and that’s the point where these things touch the political process. Given that we are talking about greater public sector involvement in the short run and a smaller role for the public sector in the medium run, political decisions will be needed to propel these processes. And in Japan, as in all countries when you deal with the financial sector, you always have a bit of inertia and vested interests.

Hilbers: This past year has been encouraging in terms of the initiatives taken by the authorities. There is a sense in Japan that things need to change and the authorities are working on them. Now it is a matter of accelerating the reforms. Prime Minister Koizumi has just won reelection and has reappointed Heizo Takenaka as the minister in charge of economic policy and financial services. This will bring continuity to the reform program and opens the way for an acceleration of the financial revival agenda.

INGVES: The “to do” list is not controversial. The debate is over how to implement it, when to start, and what the consequences will be. The key word is implementation.

IMF Survey: The FSAP is completed now; the recommendations rendered. Is that it? Will there be follow-up or monitoring of progress on these recommendations?

Key policy recommendations

Assetqualityandbankcapital

• Further strengthen banks’ provisioning for nonper-forming loans

• Limit the use of deferred tax assets in calculating bank capital

Bankrecapitalization

• Encourage banks to raise capital from the markets to meet stricter capital and provisioning requirements

• Recapitalize systemically important banks unable to raise sufficient capital in the market

• Require recapitalized banks to bring in new management

• Raise the minimum capital requirement for domestic banks to at least 8 percent

Bankgovernance

• Require banks to adopt corporate governance reforms

Corporaterestructuring

• Encourage banks to set up subsidiary “work-out” companies

• Develop further the market for distressed debt

Supervision

• Provide the financial sector supervisor (FSA) with full operational autonomy

• Provide additional resources to the FSA and continue to enhance its human capital

Governmentinvolvementinthefinancialsector

• Reduce government involvement in the financial sector by restricting the activities of the postal savings and insurance schemes and the government lending agencies

Ingves: We are moving into a world where there will be more focus on what’s going on in the financial sector in our annual Article IV consultations with member countries. What we are working on right now is defining a module dealing with the financial sector that can be included in the Article IV consultations. For those countries that have had an FSAP and recommendations, this would be a very natural follow-up.

Hilbers: This was clearly a point that our Executive Board made in its review of the FSAP earlier in the year.

Ingves: It’s very likely that Japan’s next Article IV report will contain something on the financial sector and some references to the conclusions in the FSAP and what has happened in the meantime. Over time, I suspect we are going to move toward more continuous surveillance of the financial sector in our member countries.

IMF Survey: Finally, given the size of Japan’s economy and the protracted nature of its financial sector problems, how routine an FSAP was this?

Ingves: It was a complex and lengthy process, but a very good process—one that Japan managed very professionally and took very seriously. There was a bit of diplomacy at the start. We spent some time visiting the country and explaining how an FSAP is done. You have to remember that our annual Article IV consultations with member countries have been done for the past 50 years or so and are now quite routine. When I was with the Swedish central bank and on the receiving end of an Article IV, we knew what was going to happen. We took last year’s binder and went from there.

But FSAPs haven’t been around for more than a few years. It takes some time for countries to get used to them, and the work process evolves on our side, too. FSAPs are a new concept and because some of our counterparts, such as bank supervisors, have never worked with the IMF before, we do a lot more explaining.

Hilbers: The FSAP team is also larger than most Article IV teams. It’s not just IMF staff. We have a whole range of experts from national supervisory institutions who collaborate with us, particularly in assessing compliance with international standards and codes. The experts add an element of peer review.

Ingves: That was very much the case in Japan. We had the privilege of using very experienced people from the supervisory functions of other industrial countries. So, yes, it’s a large and complex process, but a large number of countries have signed up for it, and the world is getting used to it. The process works.

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