Japan: Selected Issues
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This Selected Issues paper analyzes macroeconomic developments and prospects for Japan during the 1990s. Following a surge in activity during 1996 and early 1997, the economy fell into recession in the second quarter of 1997. Real GDP fell by 3¾ percent during the four quarters ended March 1998; the unemployment rate reached historical highs; and deflationary pressures reemerged. The downturn was largely unexpected, and most forecasters had projected growth of about 2 percent in 1997. This paper also examines fiscal policy issues for Japan.

Abstract

This Selected Issues paper analyzes macroeconomic developments and prospects for Japan during the 1990s. Following a surge in activity during 1996 and early 1997, the economy fell into recession in the second quarter of 1997. Real GDP fell by 3¾ percent during the four quarters ended March 1998; the unemployment rate reached historical highs; and deflationary pressures reemerged. The downturn was largely unexpected, and most forecasters had projected growth of about 2 percent in 1997. This paper also examines fiscal policy issues for Japan.

V. Financial Sector Reforms: Opportunities and Challenges1

1. As the “big bang” financial liberalization gathers momentum, the restructuring of the Japanese financial system is just beginning. The recently-established Financial Supervisory Agency (FSA) will have to ensure a high standard of supervision in the increasingly deregulated environment. This oversight will be especially important in the life insurance sector, where companies are suffering from declining investment yields and deteriorating asset quality, and in the securities sector, where the freeing of commissions will undermine an important source of revenue. At the same time, many corporate pension plans—which are currently under funded—will also have to be restructured.

A. “Big Bang” Financial Liberalization

2. A wide-ranging liberalization of financial markets—the so-called “big bang”—was announced by the government in late 1996.2 The “big bang” is intended to increase competition, enhance transparency, and bring the legal, accounting, and supervisory systems in line with best international practice, so as to improve the performance of the financial sector and ensure that Tokyo can offer financial services comparable in range and sophistication to those found in London and New York. The proposals included liberalizing foreign exchange regulations; freeing stock commissions; reducing the constraints on the ability of banks, insurance companies, and securities firms to compete in each other’s fields; and easing restrictions on new products. Many reform measures have already been implemented, more were enacted by the Diet as part of the comprehensive Financial System Reform Bill in early June 1998 and will be implemented during the current fiscal year, and further measures are scheduled for subsequent years (see Appendix).

3. The “big bang” is expected to trigger a major restructuring of the Japanese financial sector.3 As the range of products offered at the retail level increases, the share of personal financial assets held as deposits at financial institutions is expected to decline from its current level of over 50 percent, which is high by international standards. Firms are expected to reduce their dependence on bank financing, as foreign investment banks compete with Japanese institutions in offering innovative corporate financing alternatives. At the same time, increased competitive pressures will likely lead to consolidation in the financial sector, and the removal of the ban on financial holding companies provides the umbrella under which this can occur. The elimination of fixed brokerage commissions is already putting pressure on the earnings of securities firms, especially small- and medium-sized ones. In addition, the role of foreign firms is expected to increase, often in partnership with Japanese financial institutions—especially those in need of capital and foreign managerial and technical expertise.4

B. Government Financial Intermediation

4. An important issue that still needs to be resolved is the government’s role in financial intermediation. In particular, the Postal Saving system has an advantage over private deposit-taking institutions, because it pays no taxes or deposit insurance premia and is not subject to the same capital adequacy requirements.5 Postal saving deposits also provide an attractive hedge against an increase in interest rates, since they can be redeemed without penalty after six months. Although the interest rate on postal saving deposits is set as a fraction (usually about 90 percent) of the average 3-year deposit rate at private banks, the differential is inadequate—especially when interest rates are low—to compensate for the nonpecuniary benefits of postal saving deposits, including greater liquidity and the backing by the full faith and credit of the government. As a result, the share of personal deposits with the postal saving system in total personal deposits increased sharply during the 1990s, as market interest rates fell and concerns about the financial positions of some private institutions increased (Chart V.1).6

CHART V.1
CHART V.1

JAPAN POSTAL SAVING DEPOSITS, 1987–98

Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A005

Source: Bank of Japan.

5. Postal saving funds are placed primarily with the Fiscal Investment and Loan Program (FILP), which onlends them largely through public sector financial institutions. Some of this lending competes directly with activities of private sector financial intermediaries. (For example, outstanding mortgages by the Housing Loan Corporation exceed those by domestically licensed banks.) The government is now considering a package of reforms intended to ensure that postal saving funds are allocated by professional investment managers on commercial principles, but earlier proposals to privatize the system as part of administrative reform have been sidelined. Reforms to the FILP also are expected to improve the cost accounting of its onlending, and to reduce its automatic access to funds from the postal saving and social security systems. These measures are hoped to provide greater discipline for those agencies that depend on FILP funding.

C. New Supervisory Structure

6. Prompted by the need to ensure a high standard of financial supervision in an increasingly deregulated environment, legislation was passed that established a separate Financial Supervisory Agency (FSA), effective June 1998.7 The legislation transferred the authority for the inspection and supervision of all private financial institutions (including banks, insurance companies, and securities firms) from the Ministry of Finance (MOF) to the FSA, which is accountable to the Prime Minister. The FSA’s mandate includes the authority to grant and revoke licenses and the authority related to resolving the problems of failed financial institutions, such as issuing corrective orders, suspending business, and approving mergers. The MOF retains jurisdiction over financial system planning and formulation—this is now the responsibility of a new Financial Planning Bureau, which replaces the old Banking and Securities Bureaus.

7. The unified supervision of different types of financial institutions and the placement of this authority outside of the central bank are neither new in, or unique to, Japan. While typically in the past most industrial countries had separate regulatory bodies for banks, insurance companies, securities houses, and pension funds, over the past decade several countries—including the United Kingdom, Canada, Australia, Sweden, Denmark, and Norway—have amalgamated financial supervision and separated supervisory authority from the central bank. Other countries, including Germany and Switzerland, which still have more than one regulatory body, also separate the regulation of banks from the central bank. Unlike other countries, Japan has always had unified supervision across different parts of the financial sector and a separation of supervision from central banking.

8. By contrast, the division of supervisory responsibilities between the MOF, which is responsible for financial system policy-making, and the FSA, which is responsible for inspection and supervision, is new in Japan. The motivation for the division is the belief that the clear distinction between these functions will improve transparency and fairness, but the precise allocation of roles between the FSA and the MOF will only become clear with practice. With regard to coordination with the Deposit Insurance Corporation, there is a potential for tension between the approval of funds to individual institutions (the responsibility of the FSA) and overall policies and funding (the responsibility of the MOF).

9. The delegation of authority directly from the Prime Minister is intended to give the FSA the necessary autonomy from special-interest influence to supervise and, if necessary, sanction private financial institutions. However, some market participants have raised concerns about the degree of independence and resources of the FSA in practice.8 First, most FSA employees (over 90 percent) were transferred from the MOF and many are on secondment. Second, the FSA—as an administrative agency—is funded by the government budget, which may limit its ability to devote the appropriate level of resources to financial supervision, including in the setting of the number and remuneration of its staff.9 Third, given that the FSA has the same number of employees (about 400) as were formerly assigned to inspection and supervision at the MOF, there are concerns about the adequacy of staff resources in the context of a rapidly evolving financial environment.10

D. Life Insurance Companies

10. The April 1997 failure of Nissan Mutual Life Insurance Company—the 16th largest life insurer and the first failure of a life insurer since World War II—has drawn attention to the difficulties facing the life insurance sector. Life insurance companies have assets of ¥190 trillion, equivalent to about 38 percent of GDP (Table V.1). Life insurance policies, which account for about one-sixth of personal financial wealth and are held by about 95 percent of households, generally have large savings components, in part due to the tax-deductibility of life insurance premia.

Table V.1.

Japan: Principal Assets of Life Insurance Companies and Banks, End-1997

article image
Source: Bank of Japan.

Includes short-term deposits, entrustment of money, call loans, monetray claims, purchased, and bills purchased.

11. The performance of the life insurance sector has deteriorated in recent years because of negative spreads and declining asset quality. Losses due to negative spreads—i.e., the difference between investment returns and the yield promised to policyholders—for the eight largest life insurers increased to ¥1.2 trillion in FY1997.11 Unlike banks, life insurers hold over half of their assets in the form of securities, mostly government bonds and stocks. Reflecting declining bond yields and the weak stock market, investment returns have fallen—the sector’s average portfolio return fell from 2.93 percent in FY1996 to 2.45 percent in FY1997.12 While the promised rate of return on new life insurance policies has also declined, and is currently about 2½ percent, the average interest cost of life insurers’ long-term liabilities remains at about 4 percent, reflecting the higher contractual rates on policies written in the late 1980s and early 1990s.13

12. Asset quality also is a major problem. Life insurance companies have a substantial loan exposure to nonbank finance companies that provided funding to real estate developers, and to firms that engaged in ambitious expansion plans during the “bubble years.”14 The exposure of the sector’s loan portfolio to Asia is not disclosed, but is also thought to be significant. Second, although holdings of foreign securities (about one-tenth of total assets) consist primarily of U.S. Treasury bonds, they are believed to be mostly unhedged against exchange rate risk and to include some investments in emerging market debt instruments. Third, unrealized losses on foreign real estate investments conducted in the 1980s are believed to be substantial. Finally, the life insurance sector holds more than half of the banking sector’s total subordinated debt—this represents between 3 and 8 percent of assets of large insurance companies.

13. The scope for addressing these pressures is limited since it is difficult for life insurance companies to adjust contractual rates of return on pre-existing policies. Although promised rates of return can be cut on corporate pensions (about 25 percent of liabilities and traditionally a core business of life insurance companies), by law they cannot be cut on individual life insurance policies (about 60 percent of liabilities), except as part of workout procedures, as occurred with Nissan Mutual Life.15 Moreover, reducing rates of return leads to large withdrawals, exacerbating institutions’ cash flow problems. After life insurers reduced the return on corporate pensions from 4.5 percent to 2.5 percent in April 1996, pension managers—including the Pension Welfare Service Public Corporation, the government pension fund management institution—reacted by withdrawing large amounts of funds. As a result, the total value of individual insurance and pension policies fell in FY1997 for the first time since World War II, premium revenue declined, and policy cancellations reached unprecedented levels.

14. The mutual status of most life insurance companies limits their financing options. During the early 1990s, life insurance companies absorbed losses by realizing capital gains on their marketable securities and on real estate. However, the scope to absorb further losses has been eroded, particularly with the further declines in stock and real estate prices. Unrealized gains at the eight largest life insurers declined from ¥6.0 trillion at end-FY1996 to ¥4.1 trillion at end-FY1997, and these were concentrated in three companies.

15. Life insurance companies have attempted to improve their capital adequacy by issuing “foundation funds” (kikin). Foundation funds are deeply subordinated obligations with a fixed-charge component and maturities in the range of 3–10 years. However, life insurers may be hard pressed to earn a positive spread on the proceeds in the current low interest rate environment. An insurer’s ability to raise foundation funds is generally perceived to be a function of the strength of its business relationships with other corporations. Large life insurers typically hold substantial volumes of shares of their corporate clients, which has helped them develop business relationships that account for substantial revenues for group insurance policies. To date, it is these relationships that have provided the bulk of capital support in the form of foundation funds.16

16. The reported solvency margins of almost all the major life insurance companies—released publicly this year for the first time—are well above 200 percent (Table V.2). The only exception is Toho Mutual Life, which—along with several other companies—have announced plans to increase capital during the current fiscal year.17 The solvency margin is the ratio of total capital (assets minus liability reserves) to the control level of capital. Liability reserves consist primarily of policy reserves—broadly speaking, the net present value of contingent obligations. The control level of capital is calculated according to a formula, which takes into account the need for a minimum safety cushion against the inherent unpredictability of the insurance business. When actual capital falls to the control level of capital the solvency margin is 100 percent. The fact that 15 of the 16 major life insurance companies report solvency margins of more than 200 percent suggests that an important prudential standard is satisfied.18

Table V.2.

Japan: Solvency Margins of Life Insurance Companies, End March 1998

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Source: Nikkei News Service

17. However, the information content of solvency margins is limited by the methods used to value assets and liability reserves.19 Loan classification and provisioning practices are weak by international standards. For example, life insurance companies are not yet required to classify their loans into the four self-assessment categories already used by banks. Also, life insurance companies have not reduced the interest rate assumptions used to value liability reserves in line with declines in investment yields, resulting in inadequate liability reserves at prevailing interest rates.20

18. Financial liberalization is expected to increase competition in the life insurance sector by allowing other financial institutions to enter the sector by 2001. In the past, competition among life insurers was limited, reflecting the sector’s high degree of concentration—the top seven firms account for 70 percent of insurance premium income and some analysts report that the industry association behaves like a cartel, in that it helps to determine premium, dividend, and commission levels.21 In addition, the premium levels of the postal life insurance system (Kampo), which has a market share of about 10 percent, may act as a reference point for pricing. The need for regulatory approval of all new products, which allowed other insurers to examine and duplicate products, ensured a limited range of products with standard terms.

19. Some deregulation has already occurred following the enactment of a new insurance law in April 1996. The law allowed for greater price and product competition, and permitted direct marketing, but insurance premia continued to be set in cooperation with the industry association. The law also allowed nonlife (property and casualty, and other) insurers to engage in life insurance business through subsidiaries, which increased the number of active life insurance companies from 31 to 44.22 Finally, the law established procedures for liability transfers, mergers, liquidations, and demutualization. The shift to more efficient distribution methods, including independent brokers, direct mail, telemarketing, and the internet, is expected to result in layoffs, as sales forces typically represent the majority of a life insurance company’s employees.

20. To ease policyholders’ concerns about the life insurance sector, a policyholder protection fund will be established in December 1998 with a government guarantee on its financing through 2001.23 The technical reserves (i.e., contributions plus accumulated interest) of all life insurance policies will be fully covered until 2001 and up to 90 percent covered thereafter. The new fund will require contributions from life insurers (¥40 billion per year in addition to the amount being paid for Nissan Mutual Life), with a view to accumulating a standing amount of ¥400 billion. The government will guarantee the borrowing of the fund until 2001 and the BoJ is ready to provide short-term credit.

21. The potential for excessive risk taking, or moral hazard, is compounded by limited financial disclosure requirements, which makes it difficult for investors to evaluate the soundness of life insurance companies.24 Some analysts report that life insurers have increased their exposure to higher yield/higher risk asset classes—including middle market loans, foreign currency denominated loans, and subordinated bonds—as they seek to boost investment yield. In response to these concerns, legislation was enacted in June 1998 that will improve disclosure requirements (including the mandatory disclosure of solvency margins) and institute a system of self-assessment of asset quality and prompt corrective action, effective April 1999. With the introduction of prompt corrective action, a solvency margin below 200 percent will trigger regulatory action.

E. Securities Firms

22. The failures of Sanyo and Yamaichi Securities in November 1997 drew attention to important weaknesses in the securities sector. On November 3, Sanyo Securities—a medium sized brokerage firm affiliated with Nomura Securities—became the first Japanese securities house in the post-World War II period to file for protection from its creditors. The financial condition of Sanyo Securities had been damaged by ¥128 billion in losses on loans to nonbank affiliates and was expected to deteriorate with the liberalization of brokerage fees. As a result of its failure, Sanyo Securities defaulted on some of its obligations, most notably interbank liabilities. These defaults heightened concerns among market participants about the ability of Japanese financial institutions to honor their obligations, leading to a sharp drop in liquidity in the interbank markets and a substantial rise in the Japan premium in these markets.

23. Yamaichi Securities, the fourth largest securities house, filed on November 24 for voluntary dissolution following the discovery of ¥264 billion in off-balance-sheet losses. The losses had been hidden from the firm’s auditors since as early as 1991, mainly by being shifted to foreign accounts. The failure of Yamaichi Securities took markets by surprise, because it was considered solvent and had a well-established relationship with the large Fuyo keiretsu (to which Fuji Bank is connected). Prompt intervention by the Bank of Japan following Yamaichi’s collapse avoided a repetition of the disruption to money markets that had followed the collapse of Sanyo Securities. The BoJ made available special (Article 25) loans to facilitate the payment of the firm’s maturing obligations, and the MOF established a committee to oversee the orderly liquidation of the firm’s assets.

24. The failures of Sanyo and Yamaichi Securities have added to the pressures on securities firms stemming from their involvement in various bribery and corruption scandals. The major remaining securities houses—Nomura, Daiwa, and Nikko—have all been convicted of making illegal payments (bribes) to racketeers (sokaiyas), who extorted money using the threat to disrupt general shareholder meetings by asking embarrassing questions of management. The penalties included 2½–5 month suspensions of eligibility to underwrite government debt issues and to engage in proprietary trading. All three firms suffered declines in revenues and market shares during the investigative and penalty phases, but the longer-term financial impact is not expected to be severe, as the firms appeared to regain most of their traditional clients once sanctions expired. Following the arrests and resignations related to the scandals, the three firms have appointed new management teams, which have announced plans to improve competitiveness. Accounting irregularities have highlighted the need for improved accounting standards, better internal and external controls, and stronger corporate governance within the securities industry.

25. The failures of Sanyo and Yamaichi Securities and the sokaiya scandals depressed securities firms’ profitability in FY1997, following several years of weak performance since the collapse of the asset price bubble in the early 1990s. The weakness of the stock market cut brokerage and underwriting revenue, and losses in distressed real-estate finance affiliates required additional provisioning. As a result, many securities firms were compelled to issue subordinated debt to increase their capital adequacy ratios.

26. Financial liberalization is expected to increase competition in the securities industry by deregulating brokerage commissions and allowing entry by other financial institutions. Notwithstanding the elimination of fixed commission rates on an increasing range of securities transactions, commissions still account for a large fraction of revenue at most securities houses. Reflecting the sharp decline in commissions on large-lot transactions that followed their liberalization in April 1998, some private sector analysts estimate that up to half of this revenue base will disappear when commissions are fully liberalized in 1999. This is expected to have a large negative impact on earnings, as securities brokerage typically requires high overhead costs that may be difficult to reduce quickly.

27. The elimination of barriers between different sectors of the financial industry will likely bring about major consolidation, similar to experience in the United States following the gradual relaxation of the Glass-Steagall restrictions and in the U.K. after London’s “big bang.” Domestic banks and insurance companies are interested in establishing a presence in the securities sector, and a number of foreign securities firms already have begun to operate. The increased competition, along with the evolution of corporate governance, is expected to put greater emphasis on profitability and substantial layoffs are likely to occur. Private sector analysts expect securities firms to shed many existing employees in order to acquire staff with specialized skills and experience in new products and services, including sophisticated trading instruments, global asset management, and risk management.

28. A client protection fund will be established in December 1998, and supervision will be strengthened in FY1999. The protection fund will cover funds received from clients but not yet invested in securities, with no limit until 2001 and up to ¥10 million per client thereafter. Securities firms will be required to make contributions to the fund, with the fee schedule to be decided by the industry in consultation with the MOF. The government will guarantee the borrowing of the fund until 2001 and the BOJ would provide short-term credit if necessary. At the same time, the recently-enacted Financial System Reform Act mandates a capital adequacy requirement, with quarterly data reporting, spot checks on compliance, and large penalties for misreporting.

F. Corporate Pension System

29. There are increasing indications that the corporate pension system in Japan is seriously under funded.25 This is of concern because the system covers about 90 percent of the organized private-sector labor force and has about ¥170 trillion ($1.3 trillion) in assets. Precise estimates of the degree of underfunding are difficult because Japanese companies are not required to disclose information about their pension funds (they will only be required to do so starting in FY2000). However, analysis of the financial reports of 24 Japanese nonfinancial firms that publish their balance sheets according to U.S. Financial Accounting Standards shows that the average rate of pension asset coverage at end-FY1995 was about 75 percent and that only one pension plan was fully funded.26 More recent data from these companies indicate that the degree of underfunding has increased in the past two years. Based on these data, some private analysts estimate the total underfunding in the corporate pension system at ¥60 trillion ($460 billion).27

30. The underfunding of the corporate pension system has resulted from lower interest rates and the drop in asset prices. The decline in interest rates has significantly reduced the ability of existing funds to generate returns to cover future pension liabilities.28 Moreover, a large proportion of pension assets are invested in equities, which have fallen sharply in value. These losses have not been realized, since assets are valued at cost rather than current value. Some estimates suggest that the portion of pension fund assets held at trust banks had unrealized losses as of March 1996 of about ¥1.3 trillion, which was 5.6 percent of the pretax earnings of nonfinancial companies in FY1995. As the stock market has fallen since March 1996, unrealized losses are likely to have increased.

31. As the underfunding is likely to persist in the future, many corporate pension plans, will have to be restructured. The liberalization of pension fund management rules, including the abolition of the so-called 5-3-3-2 rule (see appendix), is expected to improve investment returns, but rising life expectancy will increase future benefits. As a result, either firms will have to devote earnings to strengthening their pension plans (i.e., increase assets) or employees will have to suffer a cut in defined benefits (i.e., reduce liabilities), or both. Another consequence of the underfunding is a rising interest in defined-contribution plans. The government is presently studying tax changes that would transform an existing savings scheme (the “workers’ property accumulation system”) into defined-contribution pensions. However, a shift to such a system would not address the accumulated unfunded liability of the current system.

APPENDIX

Financial Sector Liberalization Measures

The key measures that have already been implemented include the following:

  • Amendment of the Foreign Exchange Law: The amended law, which came into effect in April 1998, eliminated the authorized foreign exchange bank system, which required that all foreign exchange transactions be conducted through authorized banks and that the Ministry of Finance provide prior approval for large foreign currency transactions. Now all companies, including securities firms and nonfinancial companies, are permitted to trade foreign currencies. Japanese households and firms are now permitted to remit funds to foreign-based financial institutions without prenotification.29

  • Liberalization of commissions on stock transactions: Starting in April 1998, commissions were liberalized on stock transactions with a value over ¥50 million (previously the floor was ¥1 billion). In April 1999, limits on brokerage commissions will be eliminated for stock transactions of all sizes.

  • Removal of the ban on financial holding companies: Financial holding companies were banned soon after the end of World War II. Since March 1998, financial holding companies have been allowed to own controlling interests in other financial firms, such as banks, securities firms, and insurance companies, but not commercial (nonfinancial) entities.

  • Lifting of restrictions on the trading of securities derivatives: As of April 1998, derivatives and options on individual stocks may be traded over-the-counter and on stock exchanges.

  • Broadening of permissible activities: Banks are now allowed to underwrite corporate, convertible, and warrant bonds, as well as stock options, via their securities subsidiaries, and to lease office space to investment trust (mutual fund) companies for direct sales of investment trusts. Securities companies are now allowed to trade unlisted shares and to establish multi-purpose asset management accounts through which clients can make payments and settlements. Investment trusts may now hold unlisted shares, and investors may now invest in money market funds and medium-term government bond funds in any amount.

  • Abolition of the 5-3-3-2 rule: This rule required pension fund managers to hold: (i) 50 percent or more of the assets under management in bank deposits, bonds, or loans; (ii) 30 percent or less in stocks; (iii) 30 percent or less in foreign-currency denominated assets; and (iv) 20 percent or less in real property. The rule was first relaxed in 1997 for pension fund mangers who met certain criteria, and was removed entirely in January 1998.

  • Liberalization of corporate fund raising: Clarifications of the commercial code concerning perpetual bonds and medium-term notes, as well as the introduction of a more efficient “book-building method” for initial public offerings of stocks, have facilitated corporate fund raising.

  • Tightening of disclosure standards: Effective April 1, 1998, the definition of financial institutions’ nonperforming loans was broadened to include all restructured loans, including those restructured at an interest rate above the Bank of Japan’s (BOJ) discount rate, and loans that are three months past due (previously, six months past due). Also, pension funds are now required to disclose the market value of their securities holdings, rather than their cost.

    The following measures will take effect during the remainder of FY1998:

  • Removal of obstacles to asset-backed securities: Hitherto, the market for asset-backed securities had been stunted by the imposition of the securities tax on all securities transactions (making the repackaging of loans very costly) and the lack of an adequate registration system (making it difficult for purchasers of asset-backed securities to verify the ownership of underlying assets). To facilitate the creation of asset-backed securities, three changes will take effect in September 1998. First, tax and other regulations governing treatment of special purpose companies (SPCs) have been eased. Second, a new on-line central register, which will include a clear description of claims, will be established. Third, the requirement that the original borrower be notified of the sale of the loan will be eliminated.

    Further broadening of permissible activities: Banks will be allowed to sell mutual funds and new types of mutual funds will be permitted, such as incorporated and privately-placed mutual funds. The licensing requirement for securities firms will be replaced by a registration requirement. Investment advisory companies will be allowed to trade securities directly. The definition of securities will be expanded to include instruments such as depository receipts and covered warrants, which will remove ambiguity regarding their regulation. Proprietary trading systems will be allowed, and the requirement that all stock trading be conducted on exchanges will be lifted. Nonbank financial institutions will be allowed to issue bonds.

    Improved investor protection in the securities and insurance sectors: Financial disclosure rules will be strengthened, including the requirement of publication of solvency margins by insurance companies and capital adequacy ratios (still to be defined) by securities houses. Prompt corrective action frameworks, similar to that already implemented for banks, will come into effect for both sectors in FY1999.

    Industry-funded investor protection funds for customers of securities firms and policyholders of insurance companies will be established in December 1998.

    The following measures have been scheduled for implementation after FY1998:

  • Consolidated accounts: Financial information will be disclosed on a consolidated basis starting in FY1999.

  • Removal of restriction on commercial bank funding: At a date that remains to be determined, commercial banks will be allowed to issue straight bonds, reducing their dependence on deposits and further blurring the distinction between commercial and long-term credit banks.

  • Elimination of remaining barriers to entry between financial sectors: Subject to the enactment of further legislation, by the end of FY1999 restrictions on the operations of banks’ securities subsidiaries will be lifted, allowing them to deal in stocks. Banks will be allowed to compete in the insurance and securities sectors (and vice-versa) by the end of FY2000.

1

Prepared by James Morsink.

2

See Chapter VI in Japan—Economic and Policy Developments, IMF Staff Country Report No. 97/91, October 1997.

3

See, for example, Jon Choy, “Japan’s Financial Market Big Bang: The First Shock Waves,” Japan Economic Institute Report No. 22A, June 12, 1998.

4

Foreign institutions have already won a substantial share in securities trading and asset management business, and their role is likely to be extended more broadly following a series of recently announced acquisitions and strategic partnerships. For example, the Travelers Group—the U.S. financial services group—announced in early June 1998 that it would become the largest shareholder in Nikko Securities—Japan’s third largest brokerage house—and would set up jointly-owned subsidiaries to operate in key markets.

5

See Gabrielle Lipworth, “Postal Saving in Japan,” in Japan—Selected Issues, IMF Staff Country Report No. 96/114 (September 1996).

6

The share of personal deposits with the postal saving system in total personal financial assets has exhibited a similar pattern.

7

The BoJ continues to play a role in banking supervision given its ongoing responsibility for the smooth operation of the payments system. In fulfilling this obligation, it enters into contracts with individual financial institutions, which—among other things—provide for regular examinations by the BoJ.

8

See, for example, the Report of the Council of the European Business Community, “Effective and Competitive Supervision in a Deregulated Environment,” White Paper, April 1998.

9

In other industrial countries, the supervisory agency commonly levies fees on financial institutions that are being supervised.

10

The FSA supervises about 270 domestic and foreign banks, 80 insurance companies, and 230 securities companies, and directs the work of about 1,000 other staff in local finance offices, who supervise about 4,000 local cooperative financial institutions. By comparison, the number of supervisory staff in the United States is about 8,000 (of which about 1,800 are at the FDIC) and the new supervisory authority in the U.K. is expected to employ about 2,700.

11

Life insurance policies in Japan typically include a savings component, on which interest accrues at a contractual rate (set when the policy is signed). Rates on contracts signed during the 1980s and early 1990s typically were 5½ percent.

12

To boost their investment yields, life insurance companies are selling their stockholdings in major banks (life insurance companies hold about 10–15 percent of bank stock).

13

The financial position of life insurers has also been adversely affected by the increase in life expectancy, which has reduced mortality gains. Mortality gains occur when the actual mortality rate is lower than the mortality assumption (an implication of rising life expectancy), so that death benefit payouts are lower.

14

To increase asset management efficiency, some life insurance companies have started to sell bad loans, mostly unsecured loans to nonbank financial institutions.

15

The average promised rate of return on the individual policies of Nissan Mutual Life, which were transferred to Aoba Life, was reduced from 5.5 percent to 2.75 percent.

16

In the case of Nissan Mutual Life, business relationships with corporations were reportedly weak and therefore no-one was willing to fund policyholder losses.

17

Toho Mutual Life and GE Financial Insurance, the 13th largest insurer in the U.S. and a unit of GE Capital Services, established a joint venture in April 1998 to take over Toho’s new business. Toho Mutual Life now only manages its existing insurance policies.

18

Nissan Mutual Life is believed to have fallen below the 200 percent minimum requirement in March 1997, leading to the suspension of the company’s operations in April 1997.

19

This paragraph draws on Andrew Smithers, “The Japanese Life Insurance Industry,” Smithers and Co. Report No. 112, November 1997, and on industry reports prepared by Goldman Sachs, Moody’s Investors Service, and Standard and Poor’s.

20

In addition, the solvency margin gives 90 percent capital credit to unrealized gains on domestic equities, which is inconsistent with treatment of the banks, which are only allowed to count 45 percent of such gains in calculating Tier 2 capital.

21

This compares to concentration ratios of 23 percent in the United States, 33 percent in the United Kingdom, 41 percent in Germany, and 57 percent in France. See Ostrom, Douglas, “From Colossus to Casualty: The Transformation of Japan’s Insurance Industry,” Japan Economic Institute Report No. 2A, January 16, 1998.

22

However, life insurers will only be allowed to compete in the “third sector” (which is considered to have the greatest growth potential) in 2001.

23

While the industry association had established a policyholder protection fund following the enactment of the new insurance law in 1996, the size of the fund proved insufficient to cover the losses of Nissan Mutual Life, and policyholders were forced to accept a reduction in their promised rate of return. The maximum amount available from the fund was set at ¥200 billion, which was not pre-funded but was to be collected when a life insurer became insolvent, with contributions from solvent companies to be proportional to their market share of the industry’s total premium income. Following the failure of Nissan Mutual Life, the other 43 life insurers will be required to make a total annual payment of ¥23 billion for 10 years.

24

Some analysts report that Japanese accounting practices are deficient in the areas of investment quality, asset valuation, and capital adequacy, compared to financial reporting systems in the United States or the United Kingdom.

25

In Japan, the vast majority of firms have defmed-benefit pension plans. By contrast, most firms in the United States have defined-contribution plans, for which the issue of funding does not arise.

26

Teruki Morinaga and Mitsuhiro Fukao, “The Current State of the Japanese Corporate Pension System and Its Problems,” mimeo, Keio University, (March 1997).

27

By comparison, in the United States, the total underfunding of defined-benefit corporate pension plans in 1995 was $64 billion and is estimated to have fallen since then, reflecting the strong performance of the stock market. In the United States, defined-benefit plans are guaranteed by the Pension Benefit Guaranty Corporation, a U.S. federal corporation, which levies insurance premia on participating companies.

28

The two main types of private-sector pensions are Employee Pension Funds (EPFs), which are supervised by the Ministry of Health and Welfare, and tax-qualified plans (TQPs), which are overseen by the Ministry of Finance.

29

Banks are still required to notify the authorities of their foreign transactions on an ex post basis.

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