This chapter examines three issues related to developments in mature markets. As January 1999 approaches, the broader framework for financial surveillance and supervision, for ensuring financial stability, and for crisis management within the European Economic and Monetary Union (EMU) is still evolving. Against the background of implementation of the new pan-European payments system, and the likely challenges in the development of pan-European money markets and European banking systems, the first section of this chapter examines remaining challenges in setting up the EMU framework for ensuring financial stability and crisis management.

This chapter examines three issues related to developments in mature markets. As January 1999 approaches, the broader framework for financial surveillance and supervision, for ensuring financial stability, and for crisis management within the European Economic and Monetary Union (EMU) is still evolving. Against the background of implementation of the new pan-European payments system, and the likely challenges in the development of pan-European money markets and European banking systems, the first section of this chapter examines remaining challenges in setting up the EMU framework for ensuring financial stability and crisis management.

The second section discusses the performance of the Group of Seven banking systems, where the most serious challenges and risks are in Japan. Seven years after the bursting of the asset price bubble, Japan’s financial system problems have still not been resolved. While asset quality has continued to deteriorate, new problems have emerged, associated with Japanese bank exposures to crises countries in Asia, worsening financial conditions in Japan’s nonfinancial corporate sector, and emerging problems in the nonbank sector. The authorities have adopted a new strategy to resolve problems in the financial system, including the commitment of public funds to recapitalize and restructure banks, a new supervisory framework, and a timetable for deregulating the financial sector. While these measures and blueprints are promising, the first-round implementation of bank recapitalization raised concerns in international markets about the authorities’ commitment to its new approach. Moreover, details about the new supervisory agency left markets and the international community with doubts about the ability of the new agency to achieve what is required over the near term. This section also reviews the relatively good performances of the banking systems in Canada, the United States, and the United Kingdom, where the main risk is that some of them (the United States and the United Kingdom) appear to be at or near the top of a credit cycle, which is when banks tend to take on increasingly risky concentrations of loans in an effort to maintain high profitability. In Germany, relatively good performance has been tarnished somewhat by exposures to Asian countries in crisis, and in France and Italy, challenges remain for improving performance and asset quality.

The third section of the chapter discusses initiatives and remaining challenges of Group of Ten financial supervisors and regulators in their ongoing efforts to further improve financial infrastructures, encourage good private risk management and controls, improve capital adequacy requirements, and build stronger international coordination mechanisms.

Economic and Monetary Union

Implementation of TARGET

One of the main objectives of the TARGET payments system—a central feature of the financial infrastructure of EMU—is to help safeguard the prospective pan-European financial markets and financial institutions from systemic events.1 The system is composed of as many real-time gross settlement (RTGS) national payments systems as there are EMU members, linked to each other through a communications network. Cross-border payments are settled through the accounts of national central banks. Until a few years ago, most European payments systems were instead some combination of end-of-day settlement and/or netting systems, some with several settlement periods. In non-RTGS systems, financial institutions accumulate very large open positions against counterparties and run the risk of losses due to settlement failures. The advantage of RTGS systems is that each payment is made final as it occurs, so that large outstanding positions are not accumulated. This was a key reason why the EU made the decision to have national authorities incur the considerable costs to establish TARGET as a network of RTGS systems.

The 1997 Capital Markets report noted that TARGET might face competition for providing payments settlement services from other RTGS systems in Europe and private netting schemes. There is the impression in Europe that the official perception that a significant share of high-value payments—the kind of payments with systemic risk components—would be sent through TARGET might turn out to be erroneous. Large-value transactions use intraday credit, and the requirement of collateral for obtaining intraday credit within TARGET means that institutions will have to acquire and maintain collateral. Because maintaining collateral is costly, institutions might choose to use alternative netting systems, such as Euro Clearing System (ECS) and Euro Access Frankfurt 2 (EAF2),2 (which are settled at regular intervals3), for the bulk of their high-value transactions and might use TARGET only for “time critical” payments that need intraday credit.

The cost of collateral is difficult to assess because it depends on the trading opportunities lost on the underlying assets. Although some market participants consider this cost as a major hurdle in using TARGET for high-value payments, there are factors that can offset some of the cost. Both systems envisaged in EMU for depositing collateral (“pooling” and “earmarking”) may allow institutions to substitute the underlying assets on a daily basis and therefore to trade them as long as they have other eligible assets to replace them in deposit as collateral.4

Cost per transaction will be another determinant of the volume of transactions sent through TARGET. The TARGET price structure is the following: 1.75 euros for each of the first 100 transactions a month, 1 euro for each of the next 900 transactions a month, and 0.80 euro for each subsequent transaction in excess of 1,000 a month. This cost is considerably lower than earlier estimates by the European Monetary Institute (EMI), but remains high in relation to competing netting schemes. ECS and EAF2 have announced they will charge a price close to 0.25 euro for each payment.5

On July 8, 1998, the European Central Bank (ECB) announced the conditions under which London-based institutions and other non-euro credit institutions are permitted to access TARGET.6 The conditions are imposed to assure that “non-euro credit institutions will always be in a position to reimburse intraday credit in due time, thus avoiding any need for overnight central bank credit in euro.” “Safeguards will be based on the intraday credit being capped, on an early liquidity deadline and on a system of penalties in the event of a failure to reimburse the intraday credit.”7 To avoid these conditions, London-based institutions might access TARGET via subsidiaries or branches based in EMU, and these institutions will need to acquire and maintain a pool of eligible euro assets if they want to receive intraday credit.8 Using a subsidiary or a branch in an EMU country would imply more steps in the transaction and entail additional costs and risks.

The above cost and logistical considerations suggest that the TARGET payments system may not realize all of the systemic risk reductions envisioned when the system was designed, because the overwhelming majority of high-value transactions might be channeled through private and quasi-public netting systems. Although some of these systems (such as EAF2) would avoid accumulating large net exposures by introducing intraday settlement and all of them would have to satisfy the Lamfalussy standards for clearing houses,9 this is a potential problem, because some of these netting settlement systems would be considered too large to fail and would have to be underwritten and guaranteed by their respective governments. A less costly alternative for managing these risks would be to encourage the use of TARGET by abandoning the policy of full cost recovery and by reducing the need for using collateral for obtaining intraday credit, perhaps by charging fees instead as in U.S. Fedwire.10 Having the bulk of high-value payments settled in real time across TARGET could minimize the potential for problems in one European bank or banking system cascading through the euro zone.

Financial Stability and Crisis Management

Ensuring financial stability within EMU will be particularly challenging in the early years, when there might be several tendencies for systemic risks to increase temporarily. First, as already noted, there is the possibility that TARGET will not yield the expected reductions in systemic risk. Second, as new pan-European markets emerge, the growth of cross-border unsecured interbank lending could result in a higher risk of contagion, at least until the creation of an EMU-wide repo market, and the widespread use of secured (collateralized) interbank credit lines. Third, the euro is expected to accelerate the restructuring of European banking systems in an environment in which it may be difficult to close banks and to reduce costs through downsizing. In such an environment, inefficient and unprofitable institutions may continue to operate engaging in increasingly risky activities.

These tendencies to raise systemic risk may not be felt immediately, because market integration and bank restructuring may not occur quickly. This would delay the creation of pan-European markets and a pan-European banking system—and the considerable benefits for investors and consumers—but it would also provide time for adjustment. In any event, current limited cross-border mergers among European banks, gradually increasing competitive pressures in the retail sector, widespread public ownership, and still underdeveloped capital markets may provide some EMU countries with more time for the restructuring of banking systems, and the ability to continue to rely on decentralized arrangements for market surveillance and crisis management, based on home country supervision, for example. Through time, the introduction of the euro is expected to encourage the creation of a set of pan-European markets and institutions, which may require the centralization of financial surveillance, systemic risk management, and crisis resolution. Institutional arrangements in other advanced countries, including those in EMU, indicate that the central bank may be a natural place to centralize some of these functions. By drawing briefly on advanced country practices and experiences, and academic and policy literatures, the remaining parts of this section provide some perspective on these issues.11 Boxes 5.1 and 5.2 provide details about the relatively complicated separation of responsibilities between the ECB, the national central banks, national supervisors, and treasuries mandated by the Maastricht Treaty and EU legislation (including financial directives).

Against this background, the thinking and planning about crisis management is still evolving. Whereas some understanding is likely to be reached before the start of EMU, important decisions have yet to be made that will influence the way in which EMU countries would resolve a bank liquidity crisis that occurs, for example, at the fine line between monetary policy operations and liquidity support for systemically important private financial institutions. The possible need for further decisions, despite already detailed implementation of other aspects of EMU, reflects the “narrow” concept of central banking envisioned in the Maastricht Treaty. The ECB has been given the mandate to focus almost exclusively on monetary policy, and has been given only a limited, peripheral role in banking supervision and no responsibility for providing liquidity support to individual financial institutions.12 In order to implement the vision of the treaty, the EMI has organized its work to maintain a clear separation between monetary policy operations and the provision of liquidity for other reasons. The LOLR responsibility has not been assigned to any institution in EMU; consequently, there is no central provider or coordinator of emergency liquidity in the event of a crisis.

It is unclear how a bank crisis would be handled under the current institutional framework (see Box 5.1), especially if it is a pan-European bank for which supervisory and regulatory responsibilities would be shared to some extent. The main issue is whether there are effective mechanisms and understandings in place for the ESCB and/or the national central banks if it becomes apparent that a particular financial institution is having difficulties in financing some of its payments instructions sent either across TARGET for real-time settlement or across one of the alternative netting payments systems within Europe. For such situations, there is no conceptual framework that is uniformly seen as appropriate by practitioners and academics, and EMU policymakers will have to decide on a clear framework, which does not seem to be in place yet. However, it has been suggested by some European authorities that understandings have been reached by all EU supervisors through memoranda of understanding about how to deal with cross-border crises, and that discussions about the LOLR function are under way.

Some have argued that to avoid moral hazard, central banks should use only open market operations to deal with a liquidity crisis.13 By contrast, others have argued that if there is a systemic event in which there is little, or no, doubt about solvency—as with the 1985 Bank of New York computer failure—then the central bank should have the possibility of discounting assets other than eligible collateral.14 Similarly, there is a diversity of experience and practice among the major central banks. In both the United States and the United Kingdom (and in some other advanced countries), for example, central banks have considerable discretion to decide what kind of collateral to accept in exceptional circumstances to provide liquidity to the banking system. By contrast, in Germany, the Bundesbank has almost no discretion about what kind of collateral it can accept, and there has been no instance in which uncollateralized intervention was necessary.

ESCB Role in Prudential Supervision and Financial Stability

The ESCB Statute (Art. 25(1)) and the Maastricht Treaty (Art. 105(4, 5, 6)) assign to the ESCB some functions related to prudential supervision and the stability of the financial system. In addition, they give the ESCB an explicit role in promoting the smooth functioning of the payment system (Art. 22 of the Statute and Art. 105(2) of the Treaty). The 1997 Annual Report of the EMI (pp. 61–63) indicates how the EMI and the Banking Supervisory Sub-Committee expect these provisions to be implemented in EMU. Article 25(1) of the ESCB Statute envisions a specific advisory function for the ECB in the field of Community legislation relating to the prudential supervision of credit institutions and the stability of the financial system. The EMI report specifies that this function refers to the scope and implementation of Community legislation in these fields and that it should be considered “optional,” offering the ECB an instrument by which it would be able to contribute to EU legislation. Article 105(4) of the Treaty (which applies to all EU countries with the exception of the United Kingdom) contemplates a somewhat stronger role for the ECB by stipulating that it must be consulted on draft Community and national legislation falling within its field of competence. A draft Council Decision proposed by the European Commission in February 1998 and not yet approved identifies the precise scope of this provision indicating that the ECB should be consulted on rules regarding financial institutions insofar as they materially influence the stability of financial institutions and markets.

Article 105(5) of the Treaty stipulates that “the ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system.” The EMI report indicates that the main objective of this provision is to ensure an effective interaction between the ESCB and the national supervisory authorities. It has been agreed that this interaction will take two forms. First, the ESCB, and in particular the ECB, will promote cooperation among the EU national supervisory authorities (all of them, regardless of the fact that Art. 105(5) applies only to countries participating in EMU) with a view to achieving “a common understanding on relevant supervisory policy issues.” This ECB function will be performed with the assistance of a specific committee, composed of national supervisors and national central banks representatives, and is expected “to supplement” the current framework for multilateral cooperation within the EU and “to interact smoothly” with the cooperation promoted by other supervisory forums (the Banking Advisory Committee and the Groupe de Contact at the EU level and the Basle Committee at the Group of Ten level). Second, and more important, the EMI report indicates what common understanding has been reached among banking supervisors on the basic features of the flow of information to the ESCB, in light of the relevant provisions of the Bank of Credit and Commerce International Directive. The ESCB is not going to receive supervisory information on a systematic basis, so that it cannot use it for internal risk management,1 but banking supervisors “will be prepared to consider” requests from the ESCB in this area and, in the event of a banking crisis with systemic implications, to inform the ESCB on a case-by-case basis. A similar earlier agreement reached in 1994 between the Banking Supervisory Sub-Committee and the Payments System SubCommittee disciplined the flow of information between supervisory authorities and national central banks as overseers of national payments systems in the event of a payment system crisis. This agreement did not mention the ECB and will need to be updated in this respect.

Article 105(6) of the Treaty contemplates the possibility that, upon initiative of the European Commission, the EU Council of Ministers acting “unanimously” may assign “specific tasks” to the ECB in the area of prudential supervision. In this regard, the EMI report (page 62) states that “at this stage, it is felt that it would be premature to envisage any transfer of supervisory powers from national authorities to the ECB.”

1This is already the general agreement regulating relationships between central banks and supervisors in most EMU countries.

The German system is an important benchmark for examining how crisis management might take place within EMU, because the ESCB statute is similar to that of the Bundesbank in many respects. In Germany, the Bundesbank—like the ECB—has no explicit responsibility for safeguarding the stability of the financial system and it does not have a mandate as a LOLR. Indeed, the German framework for dealing with crises seems to be constructed so as to avoid a role for the Bundesbank in providing funds in rescue operations. The system, in effect, has three lines of defense: (1) supervision and regulation by an independent body; (2) short-term liquidity assistance from the Liquidity Consortium Bank combined with brokered market solutions; (3) deposit insurance and, if necessary, public funds. In practice, the Liquidity Consortium Bank—in which the Bundesbank has a stake15—has been able to identify solvent institutions to which short-term liquidity assistance should be provided thanks to the close cooperation between this bank, the independent supervisory authority, and the Bundesbank. This close cooperation has also allowed the Bundesbank to be involved in resolving problems by encouraging strong banks with ample liquidity to purchase illiquid, but sound, assets from troubled institutions in need of liquidity. Deposit insurance and public funds have been used to deal with insolvent institutions.

Remaining Scope for Lender-of-Last-Resort Operations in EMU

To evaluate the remaining scope for lender-of-last-resort (LOLR) operations in EMU, it is necessary to distinguish between the case of a local liquidity crisis affecting a large institution located in an EMU country and the case of a general liquidity crisis affecting the entire EMU. In case of a local liquidity crisis, the key issue is whether national central banks can provide liquidity support to troubled institutions without ECB authorization. This turns on whether the ECB’s Governing Council will prohibit national central banks from purchasing noneligible collateral (commercial paper or loans) from illiquid institutions, which they might purchase under an article in the ESCB statute that allows these banks to engage in activities “performed on the responsibility and liability of national central banks” (Art. 14.4).1 National central banks have scope for such operations, unless the ECB’s Governing Council prohibits them by a qualified majority vote because the operation “interferes with the objectives and tasks of the ESCB” (Art. 14.4) or with guidelines and instructions issued according to articles 12.1 and 14.3 of the Statute.2 Whether the Governing Council of the ECB will clarify this issue or maintain ambiguity remains to be seen.

National central banks may also consider indirect ways of assisting a bank experiencing severe liquidity problems. One possibility would be to swap some of the bank’s illiquid assets for liquid assets in the balance sheet of the national central bank with the latter effectively taking up the credit risk on the illiquid assets. Another possibility would be for the national central bank to guarantee the institution in trouble (or undertake other similar off-balance-sheet activities), as the Bank of England did during the 1991–93 recession when several clearing banks withdrew wholesale funds from small banks and building societies.3 The Governing Council of the ECB, however, may argue on the basis of Art. 14.4 that, although such operations do not necessarily have an impact on bank liquidity at the EMU level, they “interfere with the objectives and tasks of the ESCB.” As a consequence, the Council may issue guidelines prohibiting similar on- and off-balance-sheet operations of the national central banks or specifying that its prior authorization is required. Once more, it remains to be seen whether the Council will clarify the issue or prefer to maintain some ambiguity.4

If the guidelines are going to be strict enough to prevent national central banks from providing any form of direct or indirect liquidity assistance to a bank in trouble, there may be remaining leeway for national central banks through the definition of eligible Tier 2 collateral.5 Because eligible collateral must be accepted by all national central banks, the ECB Governing Council would have to approve such a proposal. It is unknown how this approval process would work in practice in the midst of a crisis, but cases can be imagined in which it would be costly, and pose systemic risks, to wait for such an approval process. Some have suggested that such crisis situations would be dealt with on an ad hoc, case-by-case basis, in order to avoid allowing national central banks to propose, and the Council to approve, the inclusion on a permanent basis of additional assets in the list of Tier 2 eligible collateral.

In case of a general liquidity crisis, reflecting, for example, gridlock in an EMU payments system or TARGET, the ECB may need to provide liquidity to avert a systemwide crisis. In some instances, collateralized intraday credit and extraordinary open market operations may be sufficient to inject the necessary funds. In other instances, these operations may not suffice because of lack of eligible collateral. The latter situation may arise, for example, because of a sudden increase in the volume of payments in RTGS systems like the one that took place in CHAPS, the U.K. large-value payment system, during the pound crisis of September 1992, which caused foreign exchange transactions to double.6 If banks do not have enough eligible collateral to obtain intraday credit, the probability of a systemic event could rise significantly and force the ESCB to accept noneligible paper as collateral for payments system overdrafts or open market operations. The 1987 stock market crash is another example of general liquidity crisis in which the U.S. Federal Reserve made clear that banks would have unrestricted access to the discount window so that they could keep their credit lines to brokers and securities houses open.

1Art. 14.4 of the ESCB Statute. This article was probably meant to give some leeway to national central banks in performing functions with limited liquidity impact at the EMU level, like payment of employees’ salaries or purchases of shares and real estate for the pension fund of national central banks, but the issue is whether it can be given a more extensive interpretation.2Art. 12.1 stipulates, “The Governing Council shall adopt the guidelines and take the decisions necessary to ensure the performance of the tasks entrusted to the ESCB under this Treaty and this Statute.” Art. 14.3 stipulates, “The national central banks are integral part of the ESCB and shall act in accordance with the guidelines and instructions of the ECB. The Governing Council shall take the necessary steps to ensure compliance with the guidelines and instructions of the ECB, and shall require that any necessary information be given to it.” Art. 18.1 does not prohibit these operations even though it requires that lending should be based on “adequate collateral”; this article refers to the ESCB, and not national central banks and is part of the chapter, “Monetary functions and operations of the ESCB.” Schoenmaker (1995, pp. 8–9) discusses this ambiguity.3After the clearing banks pulled wholesale funds from smaller banks, some medium-sized banks also began to have funding pressures. The Bank of England provided indirect liquidity support in the form of guarantees without which clearing banks would have not funded the troubled banks. When liquidity problems in some institutions became solvency problems, the Bank of England made provisions against the losses associated with the guarantees. Knowledge of bank balance sheets (some of the banks in trouble had capital ratios in the 12–15 percent range) allowed the Bank of England to identify 40 banks to which it provided guarantees. Neither the Bank of England nor the clearing banks made the guarantees public until the need for provisions was announced.4The occasion for clarifying this issue may be the issuance of the guidelines for the management of domestic assets and liabilities of national central banks expected by end-1998, although they may not be made public. The original purpose of these guidelines, which are still being drafted by the EMI, is to discipline not the provision of emergency liquidity assistance but only those operations of national central banks that do not reflect monetary policy decisions of the ESCB (for example, changes in each national central bank’s own bond portfolio).5Tier 2 assets will be accepted EMU-wide as collateral, but, whereas losses on Tier 1 collateral would be shared across the ESCB, losses on Tier 2 collateral would be borne by the national central bank that proposes it.6Schoenmaker (1995, p.7).

There are a number of reasons why such a framework (three lines of defense, with no central bank funds) might not be immediately applicable in the event of a crisis within EMU. First, there is no analogue of the Liquidity Consortium Bank in other EMU countries nor is one planned at the EMU level. Second, even if such institutions existed in each EMU country, they would seem inadequate in relation to the size and the cross-border systemic implications of a liquidity crisis involving a major pan-European banking group, unless such institutions were endowed with considerable resources and had a much larger access to supervisory information than what national supervisors are likely to provide to the ECB. Third, the current agreement about sharing information between the ECB and the national supervisors—which can be summarized by the formula “no real obligation, no real obstacle, and some understanding” (see Box 5.1)—would probably not give the ECB the same authority as the Bundesbank in brokering a solution to a banking crisis at the EMU level. The ECB could play this role only if it were perceived to have the same access to supervisory information at the EMU level that the Bundesbank has at the German level or if it had an independent authority to inspect counterparties in order to assess creditworthiness. Fourth, the German system worked well in an environment with relatively underdeveloped capital markets and a large share of public ownership in the banking system, which implied that any crisis would take place “in slow motion” in relation to what could happen with EMU-wide capital markets and banking systems. Finally, in an integrated EMU banking system with several EMU-wide institutions, the use of deposit insurance schemes and treasury funds would take time to determine how the financial responsibilities would be shared among national authorities, and could delay the resolution of a problem bank.

In the current institutional framework—composed of the Maastricht Treaty, the Statute of the ESCB, and the regulations and guidelines issued by the EMI—considerable uncertainty remains about the scope that national central banks might have in providing emergency liquidity assistance to troubled banks (see Box 5.2). In all relevant cases, however, the ECB appears to have either to inject extra funds into the system in the event of a general liquidity crisis or to make a decision about whether national central banks should be allowed to intervene in a local liquidity crisis. This requires access to intimate knowledge of counterparty institutions. Supervisory information would be necessary to assess the credit risk that such operations would involve in the event that noneligible collateral needed to be accepted. Moreover, the ECB would certainly be unable to rely on market assessments to distinguish between a liquidity and a solvency crisis.16

Even if the ECB is going to be minimally involved in the management of liquidity crises—possibly only to authorize or deny LOLR operations of national central banks—the current arrangements between national supervisors and the ECB about the exchange of supervisory information seem inadequate during a fast-breaking crisis. An arrangement in which the ECB does not have independent access to supervisory information on a systematic basis and in which banking supervisors “will be prepared to inform the ESCB on a case-by-case basis should a banking crisis arise” is making the ECB entirely dependent on national supervisory authorities for the information needed to make relevant decisions. In addition, the new framework is not clear about the understandings of the ECB, the 11 national central banks, the 11 supervisory authorities, and possibly the 11 treasuries in EMU. In the event of a crisis involving a European banking group, clarity and transparency about the sharing of information would greatly facilitate coordination and management during the early stages of a financial problem or crisis.

In EMU, the limited agreement on information sharing probably reflects the fact that no clear LOLR function has been attributed to the ESCB and that, at present, there does not seem to be a fully worked-out framework for crisis management in EMU. Current understandings seem to imply that crises would be managed through ad hoc arrangements to do whatever is necessary to avert systemic problems. The idea may be that in the event of a crisis, a national central bank or a national authority would find a way to provide liquidity support, and then central banks and supervisors would quietly pursue longer lasting solutions, including finding buyers.17 Whereas this lack of transparency may be interpreted as “constructive ambiguity”18 aimed at reducing moral hazard, the current understandings and arrangements within EMU would need to develop further significantly before they could be workable in an environment in which speed is increasingly becoming a critical factor in the handling of financial and systemic crises. It is believed by some European authorities that, once established, such arrangements may well not be disclosed to the general public because to do so would increase moral hazard.

The current decentralized approach leaves neither national central banks nor national governments clearly responsible for supervision of pan-European banks or for ensuring EMU-wide financial market stability. As European banking groups emerge, the questions of whether national central banks could adequately assess the risks of contagion and whether the home country central bank of each bank could be easily identified will become increasingly relevant. In addition, decentralized LOLR policies may create an uneven playing field and introduce different levels of moral hazard across EMU. At the same time, the ECB will be at the center of European financial markets without the tools necessary for independently assessing creditworthiness of counterparties or the tools to provide direct support to solvent but illiquid institutions. This is not likely to be sustainable, and the ECB may soon be forced to assume a leading and coordinating role in crisis management and banking supervision.

Developments in Group of Seven Country Banking Systems

Resolving Japan’s Financial System Problems

This subsection discusses the main issues in resolving Japan’s financial system problems, and the measures taken by the authorities to address them. It reviews developments in Japan’s banking system since the 1997 Capital Markets report, followed by an analysis of the size of the asset quality problem, based on official figures and market estimates. Next, it presents market views on why it has taken so long to address these problems, and describes the “new approach” recently adopted by the authorities to resolve banking system problems and plans for implementing Big Bang financial sector reforms. The section concludes with an examination of the remaining challenges and risks in implementing this bold new approach.

Recent Developments

During FY1997, the Japanese financial system experienced three waves of financial turbulence. First, in April 1997, Nissan Mutual was declared insolvent (the first failure of an insurance company in the post-World War II period) and 2 of the major 20 banks announced major restructuring plans. The national “city” bank Hokkaido-Takushoku (HTB) announced a plan to merge with a regional bank, and Nippon Credit Bank (NCB) announced debt charge-offs that reduced its BIS capital ratio to less than 3 percent.19 HTB’s plans to merge soon stalled over the quality of its assets and were postponed sine die in September 1997.

The second wave came on November 3, 1997, when Sanyo Securities became the first Japanese securities house since World War II to file for protection against its creditors.20 Sanyo Securities had become a source of apprehension in the previous months, after several insurance companies had been reluctant to roll over subordinated loans, reflecting concern that the broker—crippled by losses from loans to affiliates—would not survive the liberalization of brokerage fees in early 1998. The failure of Sanyo Securities entailed the default of some of its obligations, notably interbank liabilities. These defaults heightened concerns among market participants about the ability of Japanese financial institutions to honor their obligations and led to a major drop in liquidity in the interbank markets and a substantial rise in the Japan premium (see Box 5.3). On November 17, as a result of these pressures, HTB was unable to raise funds in the market and applied, with the support of its supervisors, to transfer problem loans to the Deposit Insurance Corporation (DIC) and normal assets and liabilities to Hokuyo Bank, a second-tier regional bank also based in Hokkaido.21

Turbulence in the Japanese Interbank Market

The Japanese interbank market has experienced episodes of considerable turbulence in the recent period. The turbulence originated in the first week of November 1997, when Sanyo Securities, a second-tier brokerage, filed for the commencement of reorganization proceedings. Market concerns were heightened when the reorganization of Sanyo resulted in the first-ever default on the overnight call money market. Subsequently, in the wake of this turbulence, Hokkaido Takushoko Bank (then one of the top 20 banks) failed on November 17 and Yamaichi Securities (then the fourth-largest brokerage) announced on November 24 that it would close. Observers have disagreed, however, on the extent to which the turbulence caused, or merely exposed, the weaknesses of these institutions. It is clear, though, that the turbulence was marked by dramatic shifts in interbank market rates.

Interbank market rates quickly rose to reflect the increased level of market concerns. The Japan premium—the premium over LIBOR that Japanese banks pay compared with other international banks—for three-month U.S. dollars shot up from under 10 basis points in the first week of November to about 110 basis points in the first week of December (about double the previous record high). The TIBOR (Tokyo interbank offered rate) also increased sharply, with the rate on one-month funds rising from around 50 basis points in the first week of November to around 110 basis points in the first week of December (see Figure 5.1).

The TIBOR, which is a trimmed average (disposing of the two highest and two lowest quotes), does not fully show the extent to which the interbank market also segmented in this period. That is, the interbank market began to demand high rates from institutions viewed as weak counterparties, similar to what happened in a number of other Asian markets during the emerging markets crisis. For example, the TIBOR spread between Sakura Bank (then rumored to be experiencing difficulties) and Bank of Tokyo-Mitsubishi (viewed as among the stronger Japanese banks) widened from virtually zero in early November 1997 to about 20 basis points in early December, and peaked at 35–40 basis points in January 1998; the LIBOR spread between the two banks widened considerably as well. This “tiering” occurred as the normal process of liquidity flow reportedly broke down. Market participants have suggested that major interbank players held large amounts of liquidity for themselves rather than passing it through to smaller institutions as they had in the past. These developments left a number of institutions short of liquidity, which according to some market participants may have increased the risk of a systemic collapse.

The market for term liquidity was reportedly especially tight, reflecting concerns that funds would not be available in the run-up to the end of the fiscal year in March 1998 and that smaller counterparties would not survive until then. This may account for the widening in the spread between six-month and one-month TIBOR rates early in January 1998, as the spread rose from virtually zero (and even negative in late December 1997) to about 25 basis points in the second week of January, where it generally traded until a sharp increase in the one-month rate brought the spread down abruptly toward the end of February.

Following interventions by the Bank of Japan (see Box 5.4), and in response to the announced ¥30 trillion package of emergency financial measures, the Japan premium and Tokyo interbank rates eased. The Japan premium declined from over 60 basis points to about 20 basis points between end-February and mid-March 1998, and the one-month TIBOR dropped from about 130 basis points to about 50 basis points over the same period. In the event, the end of the fiscal year was rather uneventful in the Tokyo market, owing, inter alia, to the injection of public funds and changes in accounting rules regarding the valuation of equity holdings.

While market concerns have eased significantly since the turbulence, and the Bank of Japan’s assets have declined from their recent peaks, concerns persisted after the end of the fiscal year. In April 1998, TIBOR remained somewhat above that attained at the same point in the previous year, with the one-month rate at about 61 basis points compared with about 57 basis points in April 1997, and the three-month rate at 68 basis points in April 1998 compared with 58 basis points in April 1997. The Japan premium remained at levels well above that attained at the same point in previous years, with the three-month U.S. dollar premium at 26 basis points, compared with 9 basis points in April 1997. The premium eased somewhat thereafter, but rose again in June 1998, after concerns surfaced about the financial condition of Long-Term Credit Bank. These developments likely reflected ongoing unease about the final resolution of the current situation and unresolved questions about the solvency of key institutions.

Figure 5.1.
Figure 5.1.

Japan Interbank Rates, January 4, 1996–July 13, 1998

(In percent)

Source: Bloomberg Financial Markets L.P.1Premium paid over London interbank offered rate by Japanese banks for three-month U.S. dollars.

A third wave of turbulence began on November 24, when the 100-year-old Yamaichi Securities, the fourth largest securities house in Japan, announced its intention to cease all business because of growing liquidity problems. The closure reflected the recognition of past losses from tobashi (that is, stock-trade losses made on behalf of preferred customers), which had been hidden and reshuffled for six years, mainly in foreign accounts. Yamaichi’s decision surprised the markets, because despite recent losses due to sanctions in connection with its involvement with a sokaiya group,22 the company had long-held ties with the large Fuyo keiretsu (industrial group to which Fuji Bank is connected) and was considered solvent.

Prompt intervention by the Bank of Japan after the collapse of HTB and Yamaichi (Box 5.4) avoided the repetition of the financial disruptions that followed the collapse of Sanyo Securities, but overall market conditions continued to deteriorate in December. Changing market sentiment about the likelihood of bank closures was reflected in large deposit withdrawals from weak banks, and contributed to the decision by credit rating agencies to consider downgrades for several banks. Market discipline led to a tiering in stock markets, with marked declines in stock prices of weaker banks (Figure 5.2). This divergence was intensified by a spate of bad economic news in early December, which sent Japan’s stock market to a six-year low, and raised pressures on banks whose capital bases were most vulnerable to changes in stock prices.23 The imminent implementation of the new supervisory framework, which requires supervisors to take prompt corrective action whenever banks’ capital-to-risky-asset ratio fall below a certain level, created additional constraints on banks, and was deemed partly responsible for the contraction in credit observed at that time.

Figure 5.2.
Figure 5.2.

Japan: Performance of Selected Bank Stocks, January 6, 1997–July 13, 1998

(Index, January 6, 1997 = 100)

Source: Bloomberg Financial Markets L.P.

In late December, the Liberal Democratic Party agreed to take emergency measures to stabilize financial markets and improve depositors’ confidence. These measures—which improved the ability of the authorities to deal with the problems of the financial system—were preceded by the announcement that the size of banks’ impaired loans amounted to ¥76.7 trillion or 15.4 percent of GDP. The announced measures (discussed in more detail below) centered on strengthening the financial condition of the DIC and were accompanied by several regulatory changes that assisted the major banks in observing those prudential ratios, most notably the permission to value securities at cost instead of the minimum of cost and market prices, and a first round of capital injections with public funds (Table 5.1). Although the shares of the weaker institutions surged, shares of stronger banks experienced only a moderate price increase, on the perception of a resurfacing of the “convoy system.”

Table 5.1.

Japan: Regulatory Changes in the Computation of Prudential Capitalization of Banks

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The Expansion of the Bank of Japan’s Balance Sheet

Starting in late 1997, the Japanese interbank market has experienced periods of significant turbulence. In that year normal mechanisms in the interbank market for distributing liquidity reportedly broke down amid the concerns raised by the failures of several financial institutions. In this environment, interbank lending rates rose sharply. To address these difficulties, the Bank of Japan stepped aggressively into the interbank, commercial paper, and repo markets at various points, providing large amounts of funds.

In addition to providing liquidity to the market in the immediate aftermath of the collapse of Hokkaido-Takushoku Bank (HTB) and Yamaichi Securities, the Bank of Japan’s balance sheet continued to expand in early 1998 (see table). The Bank of Japan usually provides extra liquidity ahead of the end of the fiscal year, but the amount provided in late FY1997 was about five times as much as provided by end-FY1996, resulting in a 50 percent expansion of the Bank of Japan’s balance sheet between end-October 1997 and end-March 1998. Increases in interventions by the Bank of Japan in the period often responded to market concerns reflected in interbank rates. Concerns peaked around the end of November, then eased somewhat in December as the Bank of Japan expanded its assets by ¥6.4 trillion, though rates remained at high levels. Pressures began to build again in early 1998, and the Japan premium climbed from about 50 basis points in mid-January to about 65–70 basis points in February. In response, the Bank of Japan aggressively injected more funds into the markets. The Bank of Japan’s assets rose by about ¥9 trillion during February. The expansion of the Bank of Japan’s assets accelerated in the run-up to the end of the fiscal year, as its assets rose by another¥15 trillion in the period between March 10 and March 31, 1998. In late June, it resumed large injections of liquidity, after lenders became restive on rumors concerning troubled Long-Term Credit Bank (LTCB) and money market interest rates rose again.

The Bank of Japan used a variety of mechanisms to intervene in financial markets, including repo operations (introduced at end-November 1997), commercial paper transactions, and Article 38 and Article 33 lending (these operations, known by the articles defining them in the Bank of Japan Law, are described in footnote 30 below). First, the Bank of Japan engaged in so called “twist operations,” in which it provided about ¥6 trillion through repo operations with maturities usually stretching beyond the end of the fiscal year. These operations were targeted to satisfy a strong excess demand for longer maturities, which was widely reported in the markets to have resulted from the reluctance of liquid banks to lend to weak banks—the way the interbank market would normally operate—at those maturities, in fear that borrowers would become insolvent by then. Second, Bank of Japan loans to financial institutions rose from ¥0.8 trillion in October 1997 to ¥5.2 trillion at the end of March 1998. More than half of this increase originated from the provision of funds for the unwinding of HTB’s operations under Article 38 (these loans peaked at ¥3.8 trillion in November 1997, and stood at ¥3.2 trillion at end-March 1998), with collateralized lending to institutions that were weak but deemed solvent (Article 33 lending) accounting for most of the balance, which increased fivefold in the run-up to FY1998.

Bank of Japan’s Selected Accounts

(In billions of yen; end of period)

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Source: Bank of Japan.

Reflected as of March 31 among cash collateral in exchange for Japanese Government Bonds (JGBs).

Third, the Bank of Japan engaged in operations to assist institutions in liquidating commercial paper when this market dried up. After the turbulence in November 1997, some institutions were unable to sell high-grade commercial paper in the commercial paper market in order to raise liquidity. In response to this situation, the Bank of Japan reactivated this market by buying eligible commercial paper, through prescreened auctions with institutions it normally conducts monetary policy operations with, including all of the top 19 banks. The Bank of Japan also increased its holdings of other commercial bills, with the combined stock of commercial paper and other bills as of end-March 1998 standing at ¥10.3 trillion, twice the level observed at the end of FY1996 (the average of this stock over the six months before the November 1997 turbulence was about ¥3 trillion). About half of that stock corresponded to holdings of commercial paper. Some market participants have suggested that the Bank of Japan exercised some discretion in depositing funds in individual financial institutions.

On March 31, 1998, the year-over-year increase in the Bank of Japan’s balance sheet was about ¥30 trillion, a growth rate of 45 percent. About ¥6 trillion of this expansion was accounted for by double-counting of Bank of Japan repos, owing to tax considerations that favor the booking of these operations as securities lending with cash collateral. The Bank of Japan also attributed a significant part of another ¥6 trillion increase in its assets to the rise in its holdings of Japanese Government Bonds (JGBs) linked to fiscal factors stemming from the issuance of financing bills to cover a fiscal gap between the beginning of the fiscal year and the approval of the budget (which occurred on April 8, 1998). On balance, the large provision of liquidity underpinning the expansion of the Bank of Japan’s assets (more than 30 percent, after taking into account the two items above) was translated into only a modest increase in high-powered money. Despite the significant liquidity needs faced by some financial institutions and sectors after November 1997, which resulted in the provision in the period from mid-December to mid-March of about ¥20 trillion in funds maturing after the end of fiscal year, a large part of the liquidity injected by the Bank of Japan in the period was absorbed by ¥15 trillion in sales of Bank of Japan bills (monetary management paper). Examination of banks’ balance sheets indicate a flight of customers’ deposits from banks perceived as weaker to those perceived as strong, which was not reflected in any immediate significant rebalancing of the corresponding loan books.

The Bank of Japan’s assets declined over subsequent months, but remained above precrisis levels. On June 20, 1998, its assets stood at about ¥70 trillion, about ¥7 trillion above the level at end-October 1997 (adjusted for double-counting of repos). Of this increase, more than half is due to commitments on behalf of failed institutions under Article 38 lending and loans to the DIC (both are guaranteed by the government). The decrease in Bank of Japan’s assets between end-March and the third week of June reflected a decline in outstanding repos, and more markedly of “bills purchased” with the unwinding of the “twist” operations after the closure of banks’ and firms’ books, as well as of JGB holdings after the passage of the budget. In the last week of June, developments regarding the Long-Term Credit Bank put new pressures on money markets, especially for maturities over three months (that is, stretching beyond the semiannual closure of books on September 30), and were followed by significant injections of liquidity. Surpluses on money markets of more than ¥1 trillion became common and were reflected in an increase in Bank of Japan’s holdings of JGBs.

The package constituted the first time public funds were made available on a massive scale, and calmed markets and tided banks over to the end of the year. Virtually all major banks and three regional banks received capital injections, which were of similar magnitude. The injections complemented banks’ attempts to improve capital ratios by reducing risk-weighted assets, including through the sale or securitization of about ¥4 trillion in assets, the use of credit derivatives, and the issuance of nonvoting preferred stock in international markets (at a significant premium over U.S. treasury bonds).24

The major banks took up the room provided by access to public funds and changes in accounting methods to increase their provisions and write-offs (Table 5.2), while succeeding in most cases to boost their reported prudential capital ratio. The strongest banks among the 19 core banks increased their loan loss provisions and charge offs by a factor of three to five vis-à-vis the previous fiscal year. Provisions and writeoffs for the core group as a whole doubled to ¥10.6 trillion. Because banks’ net operating profits (gyomujuneki) contracted sharply, especially among trust banks whose funding costs increased, the boost in provisions was translated into large negative pretax profits (keijo rieki) for most major banks, including all city banks. Typically, gross operating revenues declined, while general and administrative expenses were in most cases stable or slightly higher. Despite the increase in provisions, several major banks continued to be downgraded by rating agencies, on concerns about profitability and asset quality. As a step to improve market confidence, the Governor of the Bank of Japan has in recent months encouraged banks to disclose their self-assessments (Box 5.5). More recently, one of the long-term credit banks announced the intention to merge with a trust bank.

Table 5.2.

Japan: Profit and Loss Accounts of the Major Banks in FY19971

(In billions of Japanese yen unless otherwise stated)

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Source: Fitch IBCA Ltd.

Fiscal year ended March 31.

Net operating profits before specific loan loss charges and gains on the investment portfolio (source indicates that due to adjustments, this measure cannot be precisely calculated from public data).

Pretax, pre-special-item current profits that include those from securities holdings.

Size of the Bad Loan Problem

The official release of the aggregate result of banks’ preliminary self-assessments is a welcome acknowledgment that the size of problem loans is larger than has been indicated in the past (Box 5.5 describes the prudential classification used in the process, which is only partially reflected in nonperforming loan figures disclosed in banks’ financial statements).25 However, developments since these trial self-assessments were conducted suggest that Japan’s debt overhang is larger than the figures announced in January. Market participants have formulated several estimates of the risks in Asian and corporate exposures and of potential problems in non banks, such as credit cooperatives and insurance companies.

Size of Problem Loans in the Banking Sector. In May 1998, the 19 largest banks disclosed a total of ¥22 trillion in problem loans (a 20 percent increase vis-à-vis March 1997). This increase reflected new accounting rules, which accounted for 40 percent of the increase in disclosed problem loans (Table 5.4). Provisions were translated into a ¥5 trillion increase in specific provisions, but this did not correspond to a major reduction in banks’ vulnerability. The aggregate ratio of provisioned problem loans to equity increased, especially when adjusted for reductions in the value of hidden reserves related to reductions in equity prices. Because of these adjustments, the ratio exceeded 100 percent for one city bank, and two of the seven trust banks.

Table 5.3.

Japan: Self-Assessments of Loan Classifications

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Source: Bank of Japan.

The process of the change in the asset quality and the resultant lone loss ratio for each category are traced.

(I) to (IV) refer to the categories used in the Ministry of Finance’s inspection.

Table 5.4.

Japan: Asset Quaiity of Major Banks in FY19971

(In billions of Japanese yen unless otherwise stated)

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Source: Filch IBCA Ltd.

Fiscal year ended March 31.

Adjusted for holdings as securities.

As noted earlier, banks’ self-assessments of impaired loans (net of reserves) were announced in January 1998 and totaled ¥76.7 trillion. According to banks’ self-assessments, the core Japanese banks held ¥54 trillion in impaired loans, of which ¥45 trillion were classified as substandard, which corresponds to a ratio of impaired loans net of provisions to total loans of approximately 12 percent. The ratio of unprovisioned disclosed problem loans to total loans was 2 percent.

Banks were required to take a forward-looking approach to assessing asset quality. Compliance with this requirement has not been evaluated by supervisors, and the impact on asset quality of changes in economic conditions since September 1997 was largely unforeseen. There is no evidence that banks’ self-assessments anticipated the further deterioration in asset quality. As a result, market participants have estimated the impact on the original self-assessment figures of the following considerations.

(1) According to BIS statistics, as of mid-1997, Japanese banks had a total of $276 billion (about ¥36 trillion) in loans outstanding to entities in Asia outside Japan. According to the Bank of Japan, up to one-third of these loans were to foreign affiliates of Japanese companies, and there has been debate about whether parent companies in Japan would make good on the obligations of affiliates. However, self-assessment rules require that any foreign loan rescheduled due to a country’s exchange rate problems should be classified, including loans to Japanese firms. According to markets, a conservative assumption is that the proportion of these exposures that might be impaired would equal the ratio of domestic impaired loans to total loans, which would add ¥5 trillion to the self-assessment figures.

(2) A potentially greater increase in problem loans originates in the deterioration in the financial condition of the nonfinancial corporate sector in Japan. Japanese firms are highly leveraged, with leverage ratios (liabilities relative to replaceable assets adjusted for land values) three times those of U.S. nonfinancial companies and corporate loans amounting to ¥550 trillion. Further, even though Japanese lending rates have been at a historical low, interest coverage ratios (interest costs relative to operating surpluses) are higher than in other industrial countries and are expected to deteriorate (Table 5.5). Moreover, market analysts estimate that corporate profits will decline by 10–20 percent in FY1998. Finally, because 60 percent of banks’ loans are to small and medium-sized enterprises, the recent increase in bankruptcies have a large bearing in their portfolios. The nonfinancial corporate sector in Japan had in FY1997 its worst year since World War II in terms of bankruptcies. The number of companies going bankrupt rose by 17 percent, and new bankruptcy-related debts increased by 64 percent.

Table 5.5.

Japan: Selected Corporate Financial Indicators

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Source: Bank of Japan.

March 1998 (Tankan) projection.

Loans from domestic licensed banks (April 1998 column shows March 1998 stock).

Industrial shipments inflated by wholesale price index.

Markets consider it unlikely that many of the bankruptcies in late 1997 were accounted for in self-assessments, even among the substandard loans, or that bankruptcies that occurred, or are likely to occur, in 1998 were anticipated. This is because prospects for corporate profitability (captured for instance by the consensus forecast) started to decline only during the last quarter of 1997. A conservative assumption would be that between 3 percent and 5 percent of corporate borrowing from banks are, or will become, impaired in one way or another. This would add roughly another ¥20 trillion to the total potential debt overhang.

(3) About ¥10 trillion should be deducted from banks’ self-assessments to reflect provisions made by banks in FY1997 (for most banks, those figures did not reflect provisions on September 30, 1997). On the other hand, according to market sources, problem loans to affiliated companies were underrecorded by ¥5 trillion.26

Potential Problems in Nonbank Financial Sector. Among nonbank financial institutions, cooperatives (which account for about one-sixth of total loans in Japan) and insurance companies also face problems. Markets estimate that ¥18 trillion in cooperative loans are impaired (of which half constitute disclosed problem loans). In recent months, more than 30 cooperatives have applied for resolution with support from the DIC, including 3 large ones.

Banks’ Self-Assessments and the PCA Framework

The new classification system groups loans into four categories: “pass” or class I, “substandard” or class II, “doubtful” or class III, and “loss” or class IV (Table 5.3). Guidelines prepared by the Ministry of Finance establish that the classification of any loan should take into account the quality of the borrower and of collateral, which provide a forward-looking character to the classification, and help in assessing the potential magnitude of losses to be provisioned. The attempt to assess the potential magnitude of losses was implicit in another feature of the system: the split of loans for the purpose of classification. Under this arrangement, fractions of each loan would be reported in different classes, taking different risks into account. For instance, the fraction covered by collateral or guarantees might be recorded in classes I or II, depending on the quality and specificity of these enhancements. In the same vein, the part of a questionable loan already provisioned for would be deducted from the figure reported, and recorded in class I.

Banks became responsible for the amount of specific provisions set aside for individual loans, following guidelines prepared by the Japanese Association of Auditors. These guidelines suggested that provisions for loans in classes I and II should reflect the historical losses for these classes (the bad-debt result ratios), while write-offs and provisions for class III loans should take the amount appropriate for each debtor, and write-offs and provisions for class IV loans should be taken for the full amount of loss (in February 1998, the Bank of Japan published a study presenting historical transition rates for a sample of banks that could help in gauging adequate provision ratios). Although the ministerial guidelines put great emphasis on marking collateral values to market, they made few references to specific methods to account for the multitude of liens that are usually attached to an important type of collateral—real estate. The approach also did not emphasize the cost of the time it may take to take control of such collateral, although, according to some sources, banks have traditionally attempted to account for this cost by discounting the market value of collateral. External auditors will be responsible for verifying the methodology used by banks for carrying out the self-assessments and certify the results. The profession, which comprises about 10,000 practitioners plus some foreign nationals (the comparable number in the United States is about 300,000), is expected to respond to the new requirements by expanding the number and improving the training of certified public accountants.

The new PCA framework in Japan broadly parallels the approach used in the United States, but has some key differences (see International Monetary Fund, 1997). First, trigger points for most actions are lower in Japan than in the United States. Second, while supervisors in the United States can use discretion only to strengthen their actions, in Japan, discretion is reserved to weaken the supervisors’ actions. Third, the system in Japan introduces a distinction between banks with and without international activities, further lowering the trigger points for the latter (broadly, the capital ratio that triggers actions is 4 percent of risk-weighted assets for banks without international activities, compared with 8 percent for banks with international activities). Finally, while U.S. supervisors can order a bank into receivership or conservatorship in 90 days after the bank capital ratio has fallen below 2 percent, in Japan orders to suspend the whole or a part of a bank’s business can be issued only after all capital is wiped out, or after the net value of assets is clearly expected to become negative.

The difficulties the life insurance industry is experiencing stem from two sources. First, asset quality broadly parallels that of the banking sector, although market participants generally believe that the average quality of borrowers from insurance companies is lower than that from banks. Second, insurers face a serious imbalance between the return on their assets and the cost of their liabilities (a large fraction of the stock of insurance policies still carries guaranteed returns around 5 percent). Although life insurance policies generate a surplus in current revenues (inter alia because actual mortality is lower than assumed mortality), the “negative spread” on the stock of older policies is eating into the industry’s pool of capital (the nominal capitalization of the industry, that is, the difference between assets and reserves, amounted to ¥2.5 trillion in mid-1997). Moreover, market perceptions have been that many insurers started to hold unrealized losses when the Nikkei index fell below 16,000. The sector has a ¥70 trillion loan portfolio (some of it to banks). Accounting for the relatively lower quality of borrowers, an estimate of ¥20 trillion in impaired loans would be reasonable. Problems in the insurance sector could translate into downward pressure in stock markets and specific problems for banks, because insurance companies are major holders of subordinated bank debt.

Market Views on Why It Has Taken So Long to Deal with the Problem

For most of the 1990s, the authorities’ and banks’ reactions to these problems have been slow. Although three agencies were created to help deal with the disposition of bad real estate assets, their scope was limited and they have achieved very little (Box 5.6). Deposit-taking institutions have set aside almost ¥40 trillion in provisions, but most problem loans are still being carried on bank balance sheets, many of them with little provisioning. Market participants have identified at least five reasons why Japan’s financial sector problems have not yet been resolved:

  • (1) Japanese banks and officials had for a long time believed that there was time to use current earnings to build provisions and to increase earnings power. As of April 1998, market participants were indicating that the authorities and the banks were “in a state of denial” about the size of the financial system problems and the efforts it would take to resolve them.

  • (2) Western investment banks operating in Japan have indicated that the Japanese financial system does not yet have the legal infrastructure for dealing with debt restructuring in expeditious ways. The usual practice is thus to stretch out the maturity and carry the loan indefinitely.

  • (3) Japanese bank managers are perceived to have little if any incentive to alter their business practices. In particular, owing to the web of relationships between core shareholders and main customers, there are few incentives for them to improve banks’ profitability, inter alia, by aggressively pursuing collection efforts on bad loans.

  • (4) Although about ¥1 trillion in bad loans have been sold since March 1997, there are reasons why both suppliers and demanders of collateralized properties move slowly. Most suppliers—either the banks holding the bad paper, or the construction companies that borrowed—have little incentive to liquidate the questionable parts of their loan portfolios. Most bad “asset bubble” loans are seen by banks as zero cost, out-of-the-money “options” on the properties that lost value when the asset price bubble was deflated; that is, banks would receive little value by selling the loans, while low interest rates have reduced the costs of carrying them. Demand has been dampened by the multiplicity of liens on properties, problems of dealing with the ultimate borrowers, and other hurdles faced by potential buyers.

  • (5) In order for the government to force banks to restructure balance sheets (dispose of the loans), the construction industry would have to mark its assets to market, as tax regulations do not favor banks’ unilateral actions (as a rule, provisions and debt forgiveness are not automatically tax deductible). In the process, many firms in the construction- and property-related sector would likely be declared insolvent. Because the sector hires more than 10 percent of Japan’s labor force, there has been reluctance in forcing these companies to take this road unaided.

New Approach to Resolving Banking System Problems

In the last three years, the authorities have on three occasions introduced measures to address aspects of financial system problems. The first such occasion was in early 1996, when the decision was taken to reform the supervisory framework, after the large public outcry associated with the collapse and bailout of banks’ housing loan companies (jusen). The second was the announcement in late 1996 of Big Bang reforms, a blueprint to phase in free and open competition and permit market incentives to allocate capital within Japan. The third occasion was the passage of emergency measures in early 1998 in which the decision was taken to make available public funds to the DIC to enable it to guarantee all bank deposits until 2001 and to permit the recapitalization and restructuring of banks. These measures taken together constitute a bold new approach to resolving Japan’s financial system problems, including the promotion and creation of efficient and effective financial and capital markets in Japan. The bulk of these initiatives have been translated into law, and are scheduled to be implemented by 2001. More recently, a new impetus was given to initiatives for resolving real-estate-backed loans.

Use of Public Funds to Protect Deposits and to Recapitalize, Restructure, and Consolidate Banks. In December 1997, the authorities decided to provide ¥30 trillion in public funds for the purpose of strengthening the DIC and to create a financial crisis management fund. In contrast to the vocal public opposition against providing public funds to resolve problems with the jusen, this most recent initiative reflected the recognition that the resources of the DIC were inadequate.27

Resolution Agencies in Japan

The Cooperative Credit Purchase Company (CCPC) was created in 1993. The CCPC provided a mechanism to allow banks to transfer loans at a discount, thus satisfying requirements in the tax law, while avoiding bankruptcy of debtors (loan loss provisions are automatically tax deductible only when they follow the foreclosure of collateral or the sale of the loan at a loss). Banks remain responsible for covering the difference between the transfer price to CCPC and the final disposal price, and generally for managing the loan. Under its main mandate, the CCPC does not actively seek to resolve the assets under its care, and at its current pace, it will take another five to eight years to dispose of its inventory. Collections on an original portfolio of ¥15 trillion (purchased at a price of ¥5.7 trillion) have amounted to ¥1.1 trillion. Sales, which are most often arranged by debtors themselves, picked up in 1997, but are still low; moreover the disposal of the asset does not automatically entail a reduction in the debtor’s liability, which occurs only after the three parties have received an agreement from the courts.

The Housing Loans Administration Corporation (HLAC) was created in 1996 to resolve within a 10-year period some 300,000 loans left by the seven failed housing financing companies affiliated with banks (the jusen), and received an endowment of ¥0.6 trillion for this purpose. The 1,100-strong HLAC has liquidated about one-fifth of its original ¥4.6 trillion portfolio, but claims that banks have knowingly transferred to jusen their worst assets, and that as much as 10 percent of the ¥1 trillion corporate loan book it built up may be tied up to criminal (yakusa) concerns—circumstances that have hampered a speedy sale of assets.

The Resolution and Collection Bank (RCB) was, until recently, in charge of the assets of failed credit cooperatives only. RCB is the successor of the Tokyo Kyoudou Bank created in 1995 to deal with assets left by the failure of credit unions in the Tokyo region. As of end-FY1997, the RCB had received loans with a face value of ¥1.5 trillion, at an average discount of about 70 percent. Although it is a bona fide resolution bank, the RCB has also been slow in selling assets. Despite the relatively high discount at which it received most of its assets (70–80 percent), the RCB had sold only 19 percent of its inventory by end-FY1997. In particular, by April 1998, it had sold only 18 percent of the assets received in the first half of 1997.

The Deposit Insurance Act was amended to provide adequate financial resources to ensure the full protection of banks’ deposits and most credits28 until March 2001 and the efficient management of assets received from failed banks. It also provided a mechanism for the DIC to play a role in the consolidation of the banking sector. Three specific measures were taken for these purposes:

  • The DIC was to receive ¥7 trillion in the form of government bonds, plus authority to borrow, with government guarantees up to ¥10 trillion, through the issuance of bonds or through lending from financial institutions or the Bank of Japan, if required, to meet liquidity needs in purchasing assets from failed institutions.

  • The RCB had its authority expanded to permit it to take over assets from financial institutions other than credit cooperatives, and had its collection ability expanded. Also, the investigative powers of the DIC were expanded to cover the activities of the RCB.

  • Under the new scheme, in addition to protecting depositors, the DIC was allowed to purchase doubtful and other nonperforming loans from failing institutions to facilitate mergers with healthy institutions or to create a new institution by combining two or more failing institutions.

The terms under which the DIC will purchase problem loans are still unknown, and no comprehensive valuation methods (for example, analysis of future cash flows under generally applied assumptions and specific parameters of individual loans) have been adopted. In the first operation using the new framework (announced in May 1998) these prices were not disclosed, but the recapitalization effort required from the original shareholders was small in proportion to the stock of substandard loans to be bought by the DIC. A related issue is that of the price paid by receiving banks for substandard loans. In the past, banks have received these loans at face value. As the quality of these assets deteriorated, the receiving bank faced growing problems. In extreme cases, such as that of Midori Bank, the government felt compelled to recapitalize the receiving bank without penalizing its shareholders. In light of this experience, the authorities have recognized the need for transferring substandard loans at a discount.

The objective of the financial management crisis account is to permit the DIC to increase the capital base of banks for any of the following purposes: (1) to support the merger of a failed bank (the receiving bank may need additional capital to support the received assets, independent of the quality or transfer price of these assets); (2) to avert systemic risks; and (3) to protect a region from the consequence of a liquidity crisis. Banks can apply to use this facility on a voluntary basis, and purchases are to be approved by a high-level committee, based on the submission of a program for improving banks’ operations and management and criteria supporting the requirement in the law that the applying financial institutions are solvent. The facility entailed the establishment of a new account at the DIC to be used for the purchase of preferred stocks and subordinated loans or bonds issued by financial institutions until March 2001. The law required these purchases to be made under conditions that would not make future sales of these instruments difficult, but did not establish an obligation of or a time for proceeding with such sales. The facility is funded with ¥3 trillion in government bonds to be transferred to the DIC, and the DIC is authorized to issue up to ¥10 trillion in government-guaranteed bonds.

All major banks (except for Nippon Trust, which had been taken over by Bank of Tokyo-Mitsubishi) and three regional banks qualified for a first round of recapitalization in March 1998 on the grounds of averting the systemic risks, and after submitting plans to improve their operations. These plans were built around a reduction in personnel expenses, the closure of branches, and a decrease in the number of directors (Table 5.6). The contribution of these measures to the actual restructuring of banks was expected to be limited, because major Japanese banks are not generally overstaffed, and their low profitability has most often been associated with the narrowness of interest margins received (even abstracting from any operational costs, margins are deemed too narrow to permit banks to adequately remunerate their equity, or their total capital basis when the cost of subordinate debt is appropriately accounted for). Although most banks received about ¥100 billion irrespective of their needs, the terms at which the funds were provided varied among banks (Table 5.7), reflecting the committee’s judgment about the soundness of individual banks. According to the DIC, the distribution of these terms was based on the examination of banks’ self-assessments and other documents provided by banks to the committee and the Ministry of Finance. It broadly paralleled the tiering in the stock price of individual banks during the second half of 1997.

Table 5.6.

Japan: Planned Personnel and Other Expenses Included on the Application for the First-Round Capital Injection1

(In percent)

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Source: Deposit Insurance Corporation (Japan).

Fiscal year ending March 31 of the year shown.

Table 5.7.

Japan: Conditions for the Subscription of Capital Using Public Funds, March 1998

(In billions of Japanese yen unless otherwise stated)

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Source: Deposit Insurance Corporation (Japan).

Spreads measured in basis points vis-à-vis yen rates in the London market.

Basle Committee capital adequacy ratio.

In July 1998 these mechanisms were supplemented with a “bridge bank” scheme. Under the new scheme, the objective of a bridge bank is to ensure the continuation of relationships between borrowers and banks that are declared to be insolvent, while the failed institution is being resolved. While the bridging concept could be useful, it might reduce the pressure to introduce valuation mechanisms to determine the appropriate discount to be granted to banks receiving impaired loans from failed institutions. The bridge bank mechanism will work in two stages. First, the Financial Supervisory Agency (FSA) will appoint a financial administrator to manage the assets of the failed bank. The administrator will be responsible for approving loan renewals to sound borrowers, while paying due consideration to maintaining asset quality. Administrators will attempt to transfer assets to private receiver banks as soon as possible. In cases where these attempts fail, the second stage would introduce a public bridge bank, which would receive the loans of “sound borrowers in good faith,” including substandard loans. A centralized DIC committee will classify (in accordance with standards still to be defined) assets of each failed bank that will be transferred either to a public bridge bank or the RCB. Resources for refinancing these loans or disposing of them will be financed from the remaining ¥11 trillion (of the originally allocated ¥13 trillion) from the financial management account. The ¥17 trillion made available to the DIC will guarantee the losses of the RCB.29 Public bridge banks will be established as subsidiaries of a bank holding company owned by the DIC. They will have an initial life of up to two years, renewable for three additional one-year periods (similar time limits were adopted in the United States when bridge banks were used to receive assets from failed savings and loans institutions). Their operations will be subordinated to the board in charge of the financial crisis management facility. Bridge banks will continue to use staff and facilities from the failed banks, although key personnel will be recruited elsewhere by the DIC.

Reform of the Supervisory Framework. The reform is based on three components: (1) making bank managers bear the main responsibility for assessing asset quality and provisioning accordingly; (2) introducing a framework for Prompt Corrective Action (PCA); and (3) establishing a Financial Supervisory Agency separate from the Ministry of Finance. The first component calls for banks to periodically carry out a self-assessment of their portfolios (see Box 5.5). These exercises are to be verified by external auditors, and a summary of their results submitted to the supervisors, who will focus chiefly on verifying the soundness of banks’ internal control mechanisms underpinning those results. The second component establishes a set of structured early intervention and resolution rules to be applied in response to the results of banks’ self-assessments, as well as of on-site inspections (see International Monetary Fund, 1997). The third element is the consolidation in one agency of the supervisory responsibilities previously scattered around several bureaus in the Ministry of Finance. The self-assessments and prompt corrective actions were implemented in April 1998. The FSA started its operations in June 1998.

The FSA is subordinated to the Prime Minister, who formally delegates the supervisory functions to the agency, although remaining responsible for granting and revoking banks’ licenses. This delegation will permit the agency to establish its autonomy regarding the supervision and sanctioning of financial institutions, and retain sole discretion regarding the closure of these institutions. In case the agency believes a closure will raise systemic issues, it may consult with the Ministry of Finance on measures or legislation required to maintain the stability of the financial system, but whether or not the agency should issue the sanction is not a subject of consultation. The Ministry of Finance, on its part, will be responsible for “planning” and “formulating” policies for the financial system in general, while continuing to coordinate international financial affairs, most notably those related to the exchange rate. The FSA is supposed to participate in the preparation of ministerial ordinances and other regulations affecting financial institutions, but the exact sharing of responsibilities between the Ministry of Finance and the FSA is still unclear, and the authorities expect it to evolve over time. Both institutions will be responsible for running the DIC, with the FSA focusing on approving funds to individual institutions, and the Ministry of Finance on setting the overall policies and funding. They will also coordinate with the Bank of Japan at the time of intervening in financial institutions, to guarantee the provision of liquidity until the resolution of the failed bank is completed. The repayment of funds lent by the Bank of Japan in this capacity (except liquidity support) would be covered by the DIC funds.30

Under current plans, the FSA will have a staff of 403, with a substantial number of employees on secondment from the Ministry of Finance (about 80 percent of the initial staff will be transferred from the ministry). Being an administrative agency, its resources will be decided by the Budget Bureau at the Ministry of Finance. The Supervision Department at the agency will be limited to 68 persons, who will be responsible for the supervision of the 175 domestic banks, 93 foreign banks, 76 insurance companies, and 226 securities companies.31 Currently, on-site inspection cycles for banks have stretched over four-five years. Consideration has been given to reduce certain cycles by concentrating inspections on institutions that are deemed weaker than the average.

Big Bang. Big Bang reforms aim at creating a free, fair, and global market. They can be broadly divided into four groups (Table 5.8): liberalization of products and transactions, new organizational forms for financial institutions and a reduction in entry barriers, changes in the microstructure of markets, and improvements in consumer protection and fair trade.

Table 5.8.

Japan: Schedule for Reforming the Securities Market and for Big Bang Financial Reform

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Source: Japan, Ministry of Finance.Note: Codes for the timing of implementation of measures:■ = Already implemented.● = Legislated and to be implemented in FY 1998.♦ = Legislated and to be implemented after FY 1998.▲ = Data of implementation of legislated or announced changes taking effect after FY1998.

CMAs, which complement money management funds allowed in 1992, can hold a wide variety of assets, such as certificates of deposits, call loans, and close-to-maturity public and corporate bonds, but no derivatives; CMAs were enhanced by the permission of automatic deposit of wages and pensions on these accounts, and of withdrawals for payment of bills etc., which converted them into a broad support for cash management services.

Traditional Japanese investment trusts operate through a contract between the investor (who purchases beneficiary interests) and the trust (which is not incorporated). Upon their transfer to a custodian (trust bank), funds are invested and administered by one of the 48 investment trust management companies (ITMCs) with little oversight by investors or custodians. The new type of corporate trust fund might, inter alia, permit beneficiaries to be represented at the board of directors of such (incorporated) funds.

Since late-1997 banks have rented space for investment trust companies to sell funds at banks’ branches. These companies can sell products from bank-affiliated ITMCs or other (usually foreign) managers. By end-1998, banks will be allowed to engage in direct sales from all their branches.

Currently, most ITMCs are affiliated to securities houses. Securities houses can act as broker and distribute trust funds, but they do not engage directly in asset management.

Wrap accounts are investment consulting relationships in which clients’ funds are placed with one or more money managers, and all administrative and management fees, along with commissions, are wrapped into one comprehensive fee.

The ability to offer ancillary services would help financial institutions to offer wrap accounts and other comprehensive services.

Several insurance companies have formed their own ITMC, building on their experience in managing assets (banks and insurers were first allowed to establish ITMCs in 1992). Since the beginning of FY1998 insurers were allowed to distribute investment trusts (insurance companies thus began to distribute products from affiliated ITCMs, and in many cases from foreign institutions). The law will extend the scope of businesses of insurers by allowing them to hold banks as subsidiaries by FY2000.

The right to engage in transactions deemed “risky,” including OTC trade of derivatives and securities underwriting will still require the approval of supervisors.

Discretionary Investment Advisory Companies (DIACs) were granted the right to apply for ITMC status; foreign firms, once restricted to DIAC status have thus also entered the ITMC business.

Diversification of banks’ liabilities is a prerequisite to permit banks to reduce their reliance on (insured) deposits, inter alia, by opening the way for ITMCs to purchase these new liabilities, subject to asset-concentration limits.

These responsibilities include mainly the updating of records and ensuing notification of issuers (including the new mutual funds) of changes regarding shareholders’ and beneficiaries’ personal data.

Currently, banks engage in few “off-balance-sheet” activities, and these (e.g., loan guarantees) appear on their balance sheets. The widening of types of instruments permitted to banks to trade and hold (including several OTC derivatives) will require new accounting rules. Also, insurers will be required to mark-to-market their trading portfolio.

Insurers will also be required to consolidate the balance sheet of any brokerage subsidiary. As with banks, the law will require insurance and securities companies to keep financial statements at all business offices for public perusal.

Most funds do not disclose a list of their holdings, and there is no uniform marking to market of assets (e.g., unlisted bonds can be carried at cost). The disclosed riskiness of funds’ investment policies is not policed by third parties and custodian banks are not responsible for informing investors about any deviations from stated policies.

This separation was first implemented with respect to OTC trading on futures, which was allowed in FY 1997.

The securities sector scheme succeeds the custodian insurance fund. The envisaged industry-wide insurance schemes will, however, have a broader scope than simple coverage of counterparty risks, covering any shortfall not cushioned by the capital of insurers and investment trusts issuers.

The new legislation will, inter alia, permit the insurance funds to represent investors’ interests during the liquidation of failed institutions.

Some provisions toward establishing “insider trading restrictions on a consolidated basis” were included in the legislation passed in FY 1998.

Brokers routinely borrow securities when a customer makes a short sale and the securities must be delivered to the buying customer’s broker. In the United States, the Securities and Exchange Commission mandates that brokers seek permission from customers to borrow securities (such permission is usually included in the agreement signed by customers when opening their accounts), and to provide collateral when engaging in these operations.