Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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This is an insightful paper that provides a comprehensive assessment of the problems facing Japan’s financial system: its root causes, the remedial actions taken, and the scale of the problem. In his characteristically frank manner, Akira Nagashima recognizes the past policy mistakes and certain shortcomings of the initial corrective measures. In broad terms, I agree with the assessment that, with the package of measures introduced in June 1996, an institutional framework has been put in place that provides the tools, authority, and flexibility both to deal with, and prevent, problems of bank soundness. Nevertheless, many Japanese financial institutions continue to face serious asset-quality problems, requiring continued close attention.

Institutional Framework

In discussing the institutional framework, my focus will be on those aspects that require further strengthening. Nagashima has outlined changes that are in the process of being implemented to improve the situation. Given the presence of so many experts at this seminar, it will not be necessary to delve into the intricacies of bank supervision and other institutional details, but rather to concentrate on certain important issues to keep in mind as the process evolves.

In the area of bank supervision, it is encouraging to see a clear recognition of the need to break from supervisory methods of the past. This recognition is reflected in the establishment of the new independent body outside the Ministry of Finance that will be responsible for inspecting and supervising, not only ordinary financial institutions, but also agricultural cooperatives, financial institutions under the jurisdiction of ministries other than the ministry, as well as nonbanks. Hopefully, the establishment of this body will ensure that supervision is exercised in a more arm’s-length manner than in the past; that it is independent of other goals of policymakers; and that it is allocated with adequate resources. While it is not clear from press reports what role the Bank of Japan will play in the supervisory process, it would appear desirable that it remain centrally involved in supervision, given its proximity to information, its existing expertise, and its lender-of-last-resort function. In addition, following the protracted jusen drama, the importance of regulating the activities of nonbanks cannot be stressed enough, given the close interrelationship between financial institutions, and hence the systemic risk. In this regard, it would be interesting to know Nagashima’s thoughts on the difficulty the financial sector has had with the credit cooperatives. It seems that, despite the new supervisory framework, prefectural governments will continue to play a role in supervising institutions in their jurisdictions. But is it important to know how the responsibilities of the various supervisors have been clarified, and just how many players must be involved to be considered to be a problem?

As for the framework for dealing with failed institutions, Nagashima has raised the issue of the respective roles of the central bank, deposit insurance system, and the government in resolving failed institutions. Instead of entering into the debate regarding the extent to which Bank of Japan funds should be used, I will make a more general comment. It is essential that the losses be apportioned among depositors, borrowers, and the banking system in a transparent fashion and that the authorities refrain from ad hoc solutions that shift an unfair burden onto healthy institutions (as was the case in the resolution of the jusen). Indeed, it should be a matter of strict public policy that shareholders and management are accountable for past behavior.

Nagashima also identifies the inadequacy of the accounting framework as an important reason for the failure of the market to detect and rein in excessive risk-taking of imprudent lenders, particularly for real estate. From fiscal year 1997, however, Japanese accounting principles are expected to be improved. An important measure is the principle that banks’ trading accounts are marked to market. This is certainly a good measure, but it is highly desirable that all assets and liabilities are marked to market. Indeed, a partial application of marking to market is inherently arbitrary and there is concern that it may result in new accounting practices that would potentially undermine market transparency. More specifically, the accounting of banks’ equity holdings is problematic as banks’ ability to realize paper profits by revaluing their equity holdings can obscure their true profit position. Indeed, to the extent that the recent reduction in banks’ problem loans has been accompanied by a reduction in their cushion of hidden reserves, the real improvement in banks’ financial position is overstated. It therefore seems desirable to apply the principle of marking to market also for evaluating banks’ equity holdings.

A broader problem that goes beyond accounting is the systemic risk shared by all Japanese banks because of their large holdings of equity. The sharp decline in equity prices in the early part of 1997 threatens to delay the resolution of problem loans in the Japanese banking sector, due to the deterioration of banks’ capital positions. As a result of the decline in equity prices, banks will likely need to raise additional capital to maintain their capital ratios comfortably above the Basle capital adequacy requirement. Given the highly volatile nature of stock prices, it would be preferable that banks maintain their ratios well above the required minimum by strengthening their capital base through issuance of ordinary shares, preferred shares, and subordinated debt.

The Scale of the Bad Loan Problem

As for the scale of nonperforming loans, they represented about ¥29 trillion (or approximately 6 percent of GDP) at end-September 1996. While private estimates are considerably higher, these incorporate a broader definition of nonperforming loans. The ultimate loss on problem loans is likely to be much smaller than these gross amounts, as not all problem loans will prove unrecoverable, and the banks already have accumulated substantial reserves against losses. Overall, it is estimated that the major banks, on average, should require around two years to resolve their problem loans, while public money of only about 1–2 percent of GDP will likely be needed to close down some of the smaller institutions over the next decade or so. Thus, the difficulties of the Japanese financial system appear manageable, and there is little risk of a systemic crisis.

Role of Monetary Policy

It is also important to examine the role monetary policy plays in bank soundness. As Nagashima has noted, the roots of the financial sector difficulties can be traced to the bubble economy. While various factors contributed to the formation of the bubble, protracted easy monetary conditions stand out as largely responsible. Indeed, the origins of banking crises in many countries can be traced to a period of macroeconomic instability coinciding with deregulation of the financial system, without due attention to adequate supervision. In the case of Japan in the late 1980s, while inflation rose only moderately, an easy credit policy was channeled into asset markets, resulting in an asset price bubble. The question then arises: why was the bubble not recognized at the time?

On a number of occasions, Nagashima notes that monetary policy was too narrowly focused on the exchange rate in the late 1980s, and that, with hindsight, not sufficient heed was taken of the rapid rise in asset prices. The Bank of Japan’s current position is that “policy decisions should be made on an overall judgment of economic conditions. The exchange rate, although a factor to be considered, is not exclusive but only one of many factors.” I would certainly subscribe to such an eclectic approach. In fact, in the IMF’s work on Japan, we have found it useful to look at various indicators of monetary and financial conditions to evaluate the net impact of shocks, whether policy-induced or otherwise, on aggregate demand.

The IMF’s Monetary Conditions Index for Japan is a weighted sum of the short-term real interest rate and the real effective exchange rate, with the weights reflecting their respective impact on aggregate demand. The index makes it possible to look at the net impact of real interest rates and real exchange rates on the economy. In response to criticism that the index was not broad enough, and in expectation of a withdrawal of fiscal stimulus in 1997, the index was extended to include the impact of changes in fiscal policy and equity prices on financial conditions. The new index, referred to as the “Financial Conditions Index,” can be used to gauge the likely effect of various factors on financial conditions. The movement of this new index does indeed confirm that monetary conditions in the late 1980s were lax. Furthermore, in the more recent period during 1993–95, our analysis suggested that the strength of the yen compensated for the decline in the real interest rate and justified an earlier and greater monetary easing than was forthcoming. Monetary policy was too conservative at the time, perhaps in reaction to the experience of the late 1980s. In my view, the broader indices of financial conditions provide a useful input for formulating policy in a forward-looking manner that takes into account the effect of shocks on future activity. However, these indices should not be regarded as a measure of the monetary policy stance or as a target of monetary policy.

Before concluding, two broad generalizations should be made. First, markets have a tendency to lurch in certain directions from time to time. To say that the market should be allowed to operate freely does not imply that markets are always right. In this context, I note that the current pessimism in the financial markets regarding Japan’s ongoing economic recovery cannot be reconciled with recent economic indicators. This pessimism contrasts with the market’s excessive optimism in the late 1980s. Another relevant episode is the sharp appreciation of the yen in 1995 and the recent sharp depreciation. In both of these cases, myriad accounts point to why the yen would continue to move in one direction: at 80, many were saying it would go to 50, and now many predict it will go to 135. In such episodes, it is critical that policy analysts have the courage of their convictions and provide policy advice on the principle that large deviations from the fundamentals will be short-lived.

Second, no matter how sophisticated our analytical tools for ex-post assessment of events, in many cases, they will fall short on an ex ante basis. It is therefore important to anticipate the impact of new events, rather than just rely on past experiences, thus resisting the general tendency to fight the last war. While the narrow lesson derived from Japan’s experience in the late 1980s is that it is prudent to tighten monetary policy before the economy overheats, a broader lesson is that policy should be formulated in a forward-looking manner that takes into account the effects of shocks on future activity, as well as the lags between monetary actions and their economic impact. Under current circumstances—notwithstanding the sharp depreciation of the yen—the anticipated withdrawal of fiscal stimulus, the declining equity prices, and absence of any inflationary pressures, all justify the present accommodative stance of monetary policy. Such a policy stance would support the economic recovery that is ultimately the most effective means of overcoming the problems of bank soundness in Japan.

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