Prepared by Joaquim Levy.
Japanese banks have traditionally held a large portfolio of stocks. Banks1 stockholdings corresponded to about 17 percent of the capitalization of the Japanese stock market in the mid-1970s, a share that rose to more than 25 percent by 1988, reflecting the expansion in cross-shareholdings among financial as well as nonfinancial corporations. Owing to the historical appreciation of stock prices, capital gains on these stocks, until realized, were translated into sizeable hidden reserves. The Nikkei 225 stock price index increased five fold in 1970–85, and another 350 percent in the following five years. In accordance with the 1988 Basle agreement establishing the capital adequacy requirement of 8 percent of risk-weighed assets, the Japanese authorities have allowed banks to include 45 percent of hidden reserves in Tier-2 capital.
Such banks do not have a retail base, and have been under threat from the change in regulations under the “big bang” that would allow all banks to issue long-term debentures (currently a monopoly of long-term credit banks) and sell investment trusts. In the case of the long-term credit banks, greater competition will compound the loss of their franchise value that started in the 1980s with the changes in the long-term financing of large Japanese corporations (which led these banks to have an exceptionally large exposure to the real estate sector). Trust banks, which receive most of their funds for investment from pension funds and insurance companies (acting inter alia as custodians of these funds), have already been weakened by the liberalization of pension fund allocation rules. The new rules now allow professional asset management companies to handle an increasing share of pension fund resources through diversified portfolios, and have reduced the attractiveness of standard investment trusts. Trust banks (including the specialized subsidiaries of city banks) and long-term credit banks account for about 10 percent of the assets of the Japanese banking system (Table IV.1).
Strains were also felt in other sectors of the financial system, as discussed in Chapter V.
In the final months of FY 1997, four Japanese banks raised about US$5 billion in funds, using these instruments. These so-called Opco Preferred securities use a credit-linked note structure, similar to the “capital securities” or “trust-issued preferred stock” sold by U.S. banks since 1996, and refined by several European banks in 1997. Credit agencies have treated them broadly as debt-like instruments, similar to junk bonds, even if they rate them one notch above “speculative” instruments. These instruments were issued at premia of 225–440 basis points over U.S. Treasury paper, and were lightly traded afterwards (when reported premia widened to more than 600 basis points). Although not convertible (thus avoiding the risk of dilution) and nominally being perpetual securities, these securities can usually be called by the issuer after 10 years subject to supervisory approval; interest payments are tax-deductible under Japanese law. In general, these instruments are designed with U.S. pension funds in mind (i.e., satisfying the requirements of SEC’s Regulation 144a) and are most often issued by a foreign subsidiary of the concerned bank. These interest-bearing instruments have been treated by regulators as Tier-1 capital because interest payments can be missed and are non-cumulative, i.e., payments need not to be made up to investors (but the bank must pay dividends on the instrument before paying dividends on its preferred stock or its common stock). Market observers have noted, however, that failure to make these payments would have severe reflections in the access of Japanese banks to international money markets.
The LTCB is the second largest long-term credit bank, a type of bank that has relied on issuing long-term debentures to fund long-term corporate lending. The new bank would be the seventh largest in Japan.
Nonperforming loans (NPLs) are defined to include loans to borrowers in bankruptcy, loans that have been restructured, and loans with interest arrears. The shift in accounting rules implemented last March requires disclosing a loan as nonperforming when interest arrears exceed three months (previously six months) and all restructured loans with reduced interest rates or extended maturities (previously only when the interest rate was reduced below the official discount rate).
Official estimates agree that the collateral value of most impaired real-estate loans amounts to about thirty percent of the original value of the loan, reflecting broadly the 70–80 percent decline in commercial real estate prices since 1989.
Notwithstanding these difficulties, ¥3 trillion of bad real-estate loans was sold in the past year, mainly through off-shore special-purpose corporations and at discounts reportedly varying between 70 and 95 percent.
The projected income for the DIC in FY1996–2000 (including the surtax to protect deposits over ¥10 million) was ¥2.7 trillion, of which about ¥1.3 trillion was already committed by the time the HTB failed, and most of the remainder would be absorbed by HTB’s net liabilities of around ¥1.1 trillion.
According to statements by the authorities, unguaranteed loan trust and senior debts such as bank debentures are fully protected, but subordinated debt has not been explicitly included in this group. In the past, subordinated creditors (often financial institutions) have been required to bear some losses, even when the “subordination clauses” were not formally triggered by events leading to the collapse of the borrower.
On July 12, the National Land Association announced that, in cooperation with the Japanese Association of Real Estate, it would change its method of assessing the value of land held by financial institutions as collateral to one based on discounted cashflows, instead of the traditional combination of the recent sale price of nearby property and the acquisition cost of the land in question. This could constitute a first step to widespread use of those methods.
Midori Bank was set up after the Hanshin earthquake as the successor to a failed regional bank, with capital contributions from financial institutions in the Kobe region and loans from the Bank of Japan. The authorities have indicated that this was a special case and that the treatment dispensed to this bank should not be seen as setting a precedent.
The FDIC has used the bridge bank method to create 32 bridge banks from 114 separate institutions. Thirty of these institutions were resolved in seven months or less; the other two in less than 2½ years.
Such a system is similar to that provided in the U.S. Uniform Commercial Code. Since 1993 the MOF has dispensed with the need to inform debtors prior to securitizing car loan and lease receipts.
In an associated move, capital requirements on market risks were implemented in line with the amendments to the Basle Capital Accord. Banks can still change the lock-in prices of their stock holdings by selling and buying back such stocks at any time.
The Nikkei 225 index fell 8 percent between end FY1996 and FY1997, which contributed to a ¥6.2 trillion loss on the equity portfolio of the 19 major banks. At the end of FY1997, remaining hidden reserves amounted to ¥1.7 trillion, concentrated in three banks.
On-balance-sheet netting was allowed under the following conditions: (i) netting is legally enforceable; (ii) the maturity of the deposit is at least as long as the corresponding loan; (iii) the positions are denominated in the same currency; and (iv) the bank monitors the relevant exposure on a net basis.