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)| false “ Cargill, Thomas, Michael Hutchisonand Takatoshi Ito, Preventing Future Banking Crisis in Japan”, 1997, prepared for the Conference “Preventing Banking Crisis: Analysis and Lessons from Recent Bank Failures”, sponsored by the Federal Reserve Bank of Chicago and the World Bank, Chicago, June 11-13, 1997.
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Hutchinson, Michael and Kathleen McDill, “Are All Banking Crisis Alike? The Japanese Experience in International Comparison”, 1999, NBER Working Paper 7253.
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The authors are grateful to Akira Ariyoshi, Tamin Bayoumi, Christian Beddies, Charles Collyns, Charles Enoch, Peter Hayward, Marina Moretti, Elizabeth Milne, James Morsink and Toshitaka Sekine for helpful comments.
Observers have pointed out that, due to the importance of credit channels for the transmission of monetary policy in Japan, the weakening of the banks has reduced the effectiveness of loose monetary policies to stimulate the economy (Woo, 1999; Morsink and Bayoumi, 1999; Sekine, 1999).
This was in part due to the pressure of the U.S. government which took the position that the liberalization of the financial system in Japan would help address the strong dollar problem by stimulating demand for yen denominated instruments and would help U.S. financial institutions to break into the Japanese market.
By the late 1980s rated firms were able to avoid meeting the bond issuance criteria set by the Bond Issuance Committee. All rules relating to bond issues were abolished in 1996.
Marsh and Paul (1996) argue that profit margins of Japanese banks, in decline since the early 1970s, were temporarily boosted in the late 1980s by a shift toward higher risk loans.
Banks’ preoccupation with market shares is in many ways a vestige of the interest rate control regime. Under that regime, the fact that banks’ lending spreads were more or less fixed and that they derived most of their income from their interest earnings meant that their outstanding loans largely determined the size of their net income. Moreover, Noma (1986) show that Japanese banks are more interested in scale expansion than profit maximization.
Cargill, Hutchison and Ito (1997) have suggested that financial deregulation might have contributed to the speculative bubble of the 1980s.
For example, since prior to 1991 many borrowers could borrow up to 90 percent of the value of their real estate collateral, the about 50 percent drop in real estate prices between 1991 and 1998 meant that over 40 percent of such loans became uncovered.
The calculation of the domestic capital ratio requirement is different from that under the international standard. For example, the former is not based on risk-weighted assets and does not allow inclusion of non-core capital.
Japanese commercial codes allow corporations to value stock holdings in their investment accounts either at cost or the lower of cost or market value. Before 1997, banks had opted the latter method.
The ceiling for the reserve account was initially fixed at 0.42 percent of total loans in 1964 but was reduced five times down to 0.3 percent by 1989, to reflect the downward trend of historical loan loss (Federation of Bankers Associations of Japan, 1989).
Under the rules of the Basel Capital Accord (which Japanese authorities applied to Japanese banks), banks are allowed to count the general provision against loans toward tier 2 capital up to the limit of 1.25 percent of risk weighted assets.
In 1997, the authorities eliminated the option of using the reference level from the tax regulations.
These transactions take place at an initial price (which is supposed to reflect fair market value) with the explicit agreement that the final price of the transactions be established after the CCPC has managed to sell the loans.
By 1997 the CCPC had sold less than 5 percent of its portfolio.
Kawai, Hashimoto and Izumida (1996) found that firms with main banks pay significantly lower interest-rate premia than do firms without main banks.
In the United States, for instance, banks are allowed to reclassify restructured loans as performing only after the borrowers have made three consecutive payments. Until then, interest payment is recognized only on a cash basis.
Before December 1998, regulations for the purpose of consolidation and disclosure were specified as follows: the subsidiaries of banks (defined as companies of which banks have more than 50 percent stake) have to be consolidated in the financial reporting of banks on a line by line basis; the affiliates of banks (defined as companies of which banks have more than 20 percent stake) have to be consolidated in the financial reporting of banks using the equity method. In December 1998, these regulations were tightened. The subsidiaries of banks and any company of which the bank group (a keiretsu with which a bank is associated) has more than a 40 percent stake have to be consolidated in the financial reporting of the banks on a line by line basis; banks’ affiliates and any company of which a bank or bank group has more than a 15 percent stake and whose decisions are controlled by the bank should be consolidated using the equity method.
Sakura Bank raised 200 billion yen through two convertible preferred stock issues (in March 1992 and April 1994) which were converted to common stock upon maturity in June 1995 and October 1997. Daiwa Bank issued 50 billion yen of exchangeable bonds in March 1994, which were exchanged into common stock in March 1998. It also raised an additional 50 billion yen through a domestic private placement of convertible preferred stock with a thirty year maturity. Tokai Bank in 1996 raised 100 billion through a euro-market issue of 81/2 year convertible preference shares.
The decline in Sakura’s stock price around the time of its first of two equity issues may have “rattled” the regulators.
Banks have substantial exposure to each other’s stock prices through their cross-share holding arrangement (see section VI).
In Japan, banks are not allowed to use any subordinated debt issued by them to their affiliates (for definition see footnote 18) toward their tier 2 capital.
Many banks, especially city banks, had significant maturity mismatch between their assets and liabilities. This is partly because city banks (and regional banks) are not allowed to issue debentures and they were not, until October 1993, allowed to offer deposits whose maturity exceeded 3 years. This meant that their overall interest margins expanded during declines in interest rates (Bank of Japan, 1996).
Under the loans on bills arrangement, banks can always sell their holdings of bills in the secondary market including to the Bank of Japan in its repo operations. Securitization of loans on deeds, though possible, has not become common as it is in the United States.
It is difficult to evaluate the relative importance of these two factors. However, it can be argued that the fact that capital investment was stagnant for most of the 1990s undercuts the importance of the first factor.
Part of the explanation for this migration is the stamp tax levied on the issuance of bills which might have prompted the more cost conscious borrowers to shift to loans on deeds and overdraft loans.
The overdraft facility also gives more discretion to the lenders as to how they classify the loans. In this connection, the rise in overdraft loans could be interpreted as an accumulation of disguised non-performing loans. This is especially the case if we could project the aggregate size of overdraft loans to the situation of individual borrowers. Given that overdraft loans are designed for liquidity purposes and for that reason should fluctuate according to the borrowers’ receipts and payments, if they are rising at the level of each individual borrower (these numbers are not available) as they are at the aggregate level, it would suggest that banks have been accommodating the deterioration of their borrowers’ liquidity conditions.
American banks, similarly facing the introduction of the BIS capital standard in this period, were found to curtail their lending in response.
To exclude the effect of closed banks during this period, only banks that operated continuously between 1995 and 1998 are included in the sample.
Because of the very significant difference between the book value and market value of banks’ real estate holdings, the actual realized gains from the liquidation of these holdings were far greater than the change in the book value of these holdings.
When banks realize 100 percent of hidden gains in stocks by selling them in the market, these capital gains, treated as income, are taxed at the effective tax rate of approximately 50 percent.
Under Basle Capital Accord, tier 2 capital can be counted toward capital up to the amount of tier 1 capital.
The ratio of bank stock holdings to their core capital was about 300 percent for long-term credit banks and about 200 percent for city banks. A study by Nikko Research Center issued in January 1997 showed that a further decline in the Nekkei Average to the 13,000 and 18,000 range could have wiped out the unrealized capital gains of the 20 major banks.
In Japan most life insurance companies are structured as mutual companies.
This is related to the fact that as mutual companies, policy holders are nominal owners of the life insurers, and may total tens of thousands.
Japanese non-financial companies finance about 62 percent of their liabilities and equity through borrowing versus 13 percent in the U.S. in 1998 (The Bank of Japan, 1999).
Individual investors are generally small. For example, individual shareholders only account for less than 10 percent of Tokyo Mitsubishi Bank’s total outstanding shares.
The chairman of one Japanese bank was quoted as saying “Our purpose is to serve clients and Japanese industry. There must be profit, but profit must be reasonable. If we make too much profit, we are eating the profits of our clients” (Irvine, 1998).
Former executives of the now defunct Long Term Credit Bank and Nippon Credit Bank are currently facing trials for fraudulent accounting and false disclosure related to the recognition of losses for nonperforming loans of their banks.
The examination revealed that 74 percent of the jusen loans were nonperforming.
However, the agricultural cooperatives, which as a group had the largest exposure to the jusen companies, were fully reimbursed in the settlement, partly because of their political clout. The Ministry of Agriculture maintained that forcing agricultural cooperatives to incur losses would have had serious consequences for these institutions, which were not only credit institutions, but also perform joint purchasing, marketing and distribution services to farmers.
This was also the case with the agricultural and fishery cooperatives, which were supervised by the Ministry of Agriculture, Forestry and Fishery.
However, political and popular opposition was deemed to be too great to expand the scheme to cover ordinary banks. Deposit insurance fund could contribute to the resolution of a bank only to the extent that would have been required under a payoff scenario. Indeed, because of this limitation, Midori Bank had to assume nonperforming loans of the defunct Hyogo Bank that could not be written off by contribution from the deposit insurance fund.
The Deposit Insurance Corporation established the Financial Stabilization Fund, with funds provided by private financial institutions and made a capital subscription of 200 billion yen to the Housing Loan Administration Corporation, with 100 billion yen from the Financial Stabilization Fund and from the Bank of Japan.
Until 1997, the actual guarantee under the Deposit Insurance scheme was only up to ten million yen per account.
Many senior bureaucrats from the MOF and the BOJ, upon their retirement, move into high positions at commercial banks. Known as amakudari (in literal translation: “descent from heaven”), these appointments are intended sometimes as rewards for retiring officials and sometimes as part of the authorities’ response to arrest the worsening of distressed banks. Critics have pointed out that this system, by creating an interdependent relationship between the supervisors and the supervised, inevitably leads to conflicts of interest and retardation of action by the supervisors (Hsu, 1994).
Cargill, Hutchison and Ito pointed out that both deposits and lending of Tokyo Kyowa Credit Cooperative and Anzen Credit Cooperative nearly doubled between March 1992 and November 1994. The majority of the new loans made in this period eventually became nonperforming.
Securities firms are allowed to participate in the interbank market though there is a limit on the amount they can borrow. Insurance companies are allowed to participate in interbank market as providers of funds.
Although depositors had not played an active role in the corporate governance of banks until the latter part of the 1990s, the intensification of the withdrawal of their deposits from weak financial institutions in 1997 was instrumental in forcing the government to deal with the problems in the banking sector.
17 trillion yen was to be used for dealing with bank failures up until March 2001; the remaining 13 trillion is to be used for recapitalization of banks through the purchase of preferred shares and subordinated debt.
The new regulations did not, however, allowed banks that opted the cost basis accounting rule to count unrealized gain on stock securities toward their tier 2 capital.
For example, banks cut back on their lending to blue chip Japanese corporations with which they had maintained close business ties over the years but the lending to which was not profitable. Banks arranged for their security subsidiaries to help these corporations issue corporate bonds. Banks also cut back their loans to overseas corporations with high credit rating, especially after the yen had started depreciating against the dollar.
The migration of loans to blue chip firms from Japanese banks to foreign banks was most noticeable for euro-yen loans.
These schemes allow banks to engage in more risky lending to boost their margins.
These agencies are primarily providers of long-term loans to small and medium sized enterprises and housing loans. These agencies generally offer lower lending rates than banks partly because they are not profit oriented.
The FSA took over from the MOF the supervision of banks, securities firms, insurance companies and non-bank financial institutions, from the Regional Financial Bureaus the supervision of Shinkin banks, and from the prefectural governments the supervision of credit cooperatives.
Based on the result of a special inspection, the FSA declared three regional II banks (Kofuku, Kokumin, and Tokyo Sowa) insolvent and placed them under the government’s control. The FSA also recommended the merger of Hanshin Bank with Midori Bank (Midori Bank had been established, as mentioned above, to take over Hyogo Bank in August 1995 and had since been functioning like the American Resolution and Trust Corporation in western Japan). The FSA ordered two regional II bank (Namihaya Bank and Niigata-Chuo Bank) and one regional I bank (Hokkaido Bank) to increase their capital to meet the 4 percent CAR. Kofuku, Kokumin, Tokyo Sowa, Namihaya Bank and Niigata-Chuo Bank all went into bankruptcy in 1999.
Mitsui Bank and Taiyo-Kobe Bank merged into Sakura Bank in 1990 and Kyowa Bank and Saitama Bank merged into Asahi Bank in 1991.
Some critics of the planned mergers, while raising questions about whether they are likely to generate real restructuring, have pointed out that the mergers could further undermine the discipline in the system by making banks even bigger for the authorities’ “too big to fail” strategy (Nikkei, December 8, 1999).
Merrill Lynch bought Yamaichi Securities in 1998.
Many industry analysts have pointed out that to increase profitability, Japanese banks must cut back on their low margin volume lending.
Banks were not allowed to set up securities subsidiaries until 1994.