This paper provides a brief overview of the causes of the poor economic performance of Japan in the 1990s, and a more detailed analysis of developments in the real sector during 1999. The paper highlights that the collapse of the asset price bubble in 1990–91 provided the trigger for the downturn in 1992, and compounded the economic problems thereafter through its effects on the banking system. This paper also analyzes the fiscal policy developments and the monetary developments in Japan.


This paper provides a brief overview of the causes of the poor economic performance of Japan in the 1990s, and a more detailed analysis of developments in the real sector during 1999. The paper highlights that the collapse of the asset price bubble in 1990–91 provided the trigger for the downturn in 1992, and compounded the economic problems thereafter through its effects on the banking system. This paper also analyzes the fiscal policy developments and the monetary developments in Japan.

IV. Banking System Issues1

1. The Japanese authorities have over the past year tightened bank regulation and supervision and put in place a comprehensive framework for addressing banking system problems. Regulation and supervision has improved under the Financial Supervisory Agency (FSA), established in June 1998. Legislation was enacted in October 1998 that sharply increased public funds available to deal with banking problems, toughened the conditionally for bank recapitalization with such funds, and created the mechanism for the nationalization of failed banks. Looking ahead, the principal remaining challenges for banks are to set aside adequate provisions for loan losses, address other sources of capital weakness, and restore core profitability. Progress in these areas is important given the planned reintroduction of limited deposit insurance coverage after March 2001. This chapter provides an overview of the key issues in the banking system, discusses the main policy developments, and describes remaining challenges.

A. Overview

2. During much of 1998, market perceptions of the financial soundness of most major banks deteriorated. Bank stock prices fell, credit ratings were downgraded, and funding spreads widened (Figure IV.1). The visible difficulties of one of Japan’s major banks and the apparent political deadlock over plans to inject public money into troubled banks contributed to the intensification of market tensions.



Citation: IMF Staff Country Reports 1999, 114; 10.5089/9781451820584.002.A004

Sources: WEFA; and Bloomberg Financial Markets L.P.1/ Average U.S. dollar LIBOR of Fuji Bank, Bank of Tokyo-Mitsubishi, and Norinchukin Bank minus the LIBOR fix.2/ Highest rate minus lowest rate.

3. In response to increasing banking system strains, legislation was enacted in October 1998 that provides a broad framework for resolving banking problems. A start has been made in applying the new instruments: two major banks were nationalized in late 1998, most remaining major banks were recapitalized with public funds in March 1999, and the authorities have begun addressing problems in regional banks. In addition, the FSA conducted on-site inspections of all major banks in the summer and fall of 1998 and of all regional banks in the winter and spring of 1999. The expectation of public capital injections helped strengthen bank equity prices (although their relative value has fallen again recently), and the ample provision of funds by the Bank of Japan (BOJ)—especially since February 1999—led to the virtual disappearance of the Japan premium.

4. Major banks’ performance in FY1998 remained weak, although virtually all major banks reported capital ratios above 10 percent for March 1999. Major banks made loan loss charges of¥10 trillion, bringing cumulative loan loss charges since April 1990 to over ¥47 trillion (9½ percent of GDP). Loan loss charges were almost four times net operating profits (gyomu-juneki), resulting in substantial net losses (Table IV.1 and Figure IV.2). The banks’ net losses would have been even larger in the absence of an accounting change that allowed them to post deferred tax credits of ¥2.5 trillion in their unconsolidated accounts. Public funds and deferred tax assets together accounted for more than half of Tier-1 capital as of March 1999. Despite the substantial net losses, major banks continued to pay dividends.



(In trillions of yen)

Citation: IMF Staff Country Reports 1999, 114; 10.5089/9781451820584.002.A004

Source: FitchIBCA.
Table IV.1.

Japan: Major Banks’ Profits and Capital, FY1997–98

(Billions of yen)

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Source: Fitch IBCA.

Before specific loan loss charges and equity capital gains (gyomu-juneki).

Total provisions and charge-offs (banking account).

After special items and taxes.

Consolidated basis.

5. Notwithstanding recent progress, Japan’s banking problems continue to be an important source of vulnerability for macroeconomic performance. Until these problems are dealt with, prospects for a durable recovery will continue to be blighted by a weak banking system unable to play its proper role in financial intermediation. The urgency of action is highlighted by the expiration of the current blanket coverage of deposit insurance after March 2001. Serious weaknesses remain in three key areas:

  • Bad loans are still not fully recognized and adequately provisioned. The scale of uncovered losses remains a major source of uncertainty.

  • Capital adequacy remains suspect, reflecting not-only inadequate provisioning, but also unusually large deferred tax assets and the use of book rather than market valuation of securities holdings.

  • Core profitability is weak, due in particular to the large scale of corporate lending, on which the interest margin is thin.

Asset quality

6. While supervisory standards have improved, concerns remain that uncovered losses from nonperforming loans (NPLs) are substantial. There are three main measures of problem loans in Japan:

  • The traditional disclosure standard for NPLs is set by the Federation of Bankers Associations (FBA) (Table IV.2). This measure include loans to borrowers in legal bankruptcy, past due loans in arrears by 3 months or more, and restructured loans. Starting in March 1999, banks are allowed to charge-off problem loans that are fully covered by specific reserves before legal insolvency proceedings are completed (these are know as “partial charge-offs”). This change reduced reported NPLs but also decreased reported reserves.2 By this standard, major banks’ NPLs in March 1999 amounted to ¥20.2 trillion—or ¥27.0 trillion if partial charge-offs are added back. Against these NPLs, major banks held loan loss reserves of ¥10.5 trillion—or ¥16.7 trillion including partial charge-offs.

  • The recently-enacted Financial Reconstruction Law requires the disclosure of the substandard portion of Class 2 loans, i.e., watchlist loans that are in arrears by at least three months or for which there has been a change in terms or conditions beneficial to the debtor, in addition to doubtful loans (Class 3) and unrecoverable loans (Class 4). On this definition, which is somewhat broader than the FBA definition because it includes claims other than loans such as guarantees and foreign exchange assets, major banks’ NPLs in March 1999 amounted to ¥28.0 trillion.

  • Banks’ own self-assessments of asset quality prepared to assess the adequacy of provisioning cover watchlist loans (Class 2), doubtful loans (Class 3), and unrecoverable loans (Class 4). Unlike the two other measures, this one includes all Class 2 loans. Banks are not required to publicly disclose this information, but the FSA reports aggregate amounts for groups of banks with a delay of about four months. Major banks’ classified loans, net of collateral, guarantees, and specific loan loss provisions, amounted to ¥44.2 trillion in September 1998.

Table IV.2.

Japan: Major Banks’ Problem Loans, March 1999

(Billions of yen)

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Source: Fitch IBCA.

Partial charge-offs.

Class 3 and 4 loans.

Substandard portion of class 2 loans.

7. The size of likely uncovered losses associated with problems loans is highly uncertain. A conservative estimate can be derived from banks’ self-assessment results (Table IV.3). Using actual provisioning rates for various categories of loans—disclosed by the Financial Reconstruction Commission (FRC)—and a BOJ study of banks’ past loss experience, the classified loans for September 1998 (the latest available) would imply uncovered losses in all banks of ¥14 trillion. If potential losses in credit cooperatives are included (based on data for March 1998), total uncovered losses would be ¥17 trillion (about $140 billion or 3 ½ percent of GDP), somewhat smaller than the ¥ 19 trillion estimated last year (see the 1998 Selected Issues paper).

Table IV.3.

Japan: Estimated Uncovered Loan Losses, September 1998

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Sources: Financial Revitalization Commission; Financial Supervisory Agency; Bank of Japan Quarterly Bulletin, “Utilization of Financial Institutions’ Self Assessment in Enhancing Credit Risk Management,” February 1998; and staff estimates.

Net of specific provisions. Gross data are not reported.

Uncovered losses are the difference between appropriate and actual provisions. In turn, actual provisions are equal to gross loans minus net loans. So, uncovered losses = (appropriate rate-actual rate)* (net loans/ (1 -actual rate)).

Including LTCB and NCB.

Based on loan loss provisions at major banks.

Derived from Bank of Japan study.

8. While banks have made substantial additional loan loss provisions since September 1998, remaining uncovered losses are likely to be considerably higher for two reasons. First, banks may have been overly optimistic in loan classification, especially with regard to the impact of the current recession on loan quality. Second, loss rates—especially for class 2 loans—may be higher in the future than during the mid-1990s when most banks were not actively disposing of bad loans.

Capital Position

9. Notwithstanding banks’ relatively high reported capital ratios, serious concerns remain about capital adequacy. The failure of Long-Term Credit Bank (LTCB) demonstrated that measured capital adequacy may provide little indication of a bank’s true financial position: LTCB reported a capital adequacy ratio of 10.3 percent for March 1998, but was subsequently found to have negative net worth of¥2.5 trillion (equivalent to 14.4 percent of risk assets) as of October 1998, It appears unlikely that the entire deterioration in the bank’s capital strength occurred just during this seven-month period. While inadequate loan loss provisions are clearly the primary concern, there are four other important issues:

  • Deferred tax assets, which relate to anticipated future tax deductions for loan losses against loans that have already been provisioned against, amounted to about one-third of major banks’ Tier-1 capital as of March 1999.3 Given that the realization of these credits depends on future taxable income, and that the prospects for bank profitability are uncertain, the regulatory ceiling on deferred tax assets of five years’ taxable profit would appear to be too high. For example, in the United States, deferred tax credits are limited to 10 percent of Tier-1 capital or one year’s taxable profit, whichever is smaller.

  • Unrealized losses on securities holdings: Banks are allowed to value securities holdings at cost, rather than the lower of cost or market (LOCOM), and in practice only one major bank—Bank of Tokyo-Mitsubishi—still uses LOCOM. Although major banks in aggregate had net unrealized gains on listed securities of ¥2.1 trillion as of March 1999, several banks carried significant unrealized losses. Moreover, major banks’ large equity holdings (whose market value is roughly 2½ times banks’ own equity) imply a significant exposure of capital to market risk. Mark-to-market accounting will be required by March 2001.

  • Banks with only domestic operations are required to maintain a capital adequacy ratio of just 4 percent. While banks with international operations, including all major banks, must have capital adequacy ratios of at least 8 percent, more than half of Japan’s 121 regional banks reported capital adequacy ratios below 8 percent as of March 1999. While 20 out of 64 first-tier regional banks reported capital below 8 percent, 43 out of 57 second-tier regional banks fell short.


10. Japanese major banks’ core profitability remains weak compared to internationally active banks in other industrial countries. Weak profitability is not due to high costs: Japanese major banks have relatively low ratios of costs to revenues compared to major banks around the world, mostly because they employ few people and spend little on technology (Atkinson and others, 1999). However, Japanese banks have relatively low revenues compared to their huge asset bases—their return on assets is about one-third to one-half that of large U.S. banks. The main reason for major banks’ low revenues is that their primary business is corporate lending, on which interest margins are as thin in Japan as they are in other industrial countries. While large-scale, low-margin corporate lending was important in other countries in the past, over time banks elsewhere have expanded their retail lending operations and moved into more profitable lines of business, such as the production of “leveraged loans,” i.e., loans that are repackaged and sold to institutional investors and other nonbank institutions (through securitization). As a result, in other countries average interest margins have widened and fee income has grown.

11. Besides the need for a strategic reorientation, banks must compete in mortgage lending with the government’s Housing Loan Corporation (HLC) and in deposit taking with the Postal Savings System. Outstanding mortgages by the HLC, which offer low interest rates, exceed those by domestically licensed banks. While the Postal Savings System pays no taxes or deposit insurance premia, and is not subject to capital adequacy requirements, postal savings deposits pay attractive rates and are viewed as being backed by the full faith and credit of the government (see Lipworth, 1996). At the same time, long-term postal savings deposits are in fact very liquid, as they can be redeemed without penalty after six months, which provides an attractive hedge against an increase in interest rates. 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 not sufficient—especially when interest rates are low—to compensate for the nonpecuniary benefits of postal saving deposits. 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 (Figure IV.3).



Citation: IMF Staff Country Reports 1999, 114; 10.5089/9781451820584.002.A004

Source: Bank of Japan.

B. Main Policy Developments

12. The authorities have made important progress in addressing banking problems during the past year. Through its on-site inspections of all major and regional banks, the newly-established FSA has improved the recognition of the bad loan problem. At the same time, a comprehensive framework—backed by public money and administered by the FRC—was created to resolve banking problems. Together, strengthened supervision and an improved resolution framework laid the groundwork for the recapitalization of weak but solvent major banks, the nationalization of two insolvent major banks, and interventions in regional banks. Banks receiving public funds announced restructuring plans that point in the right direction. These actions reduced concerns about the stability of the banking system—as reflected in the virtual disappearance of the Japan premium—and are providing a window of opportunity for further reform.

Legislative framework

13. Legislation approved in October 1998 expanded and strengthened the framework for ensuring banking system stability. The new resolution framework, which is set to expire in March 2001 when limited deposit insurance is scheduled to be reintroduced, has three main components:

  • The amount of public funds available to deal with banking problems was doubled to ¥60 trillion ($500 billion or 12 percent of GDP). Of this total amount, ¥25 trillion is targeted at the recapitalization of weak but solvent banks, ¥18 trillion at nationalization and bridge banks,4 and ¥17 trillion at deposit payoffs.

  • A new high-level body—the FRC—was established to oversee banking system stability and restructuring. The FRC, headed by a cabinet-level minister, is responsible for inspection and supervision, recapitalization, and nationalization. The FSA, which assumed inspection and supervisory responsibilities from the Ministry of Finance (MOF) in June 1998, was placed under the FRC. The FSA will acquire the financial planning system function from the MOF in 2000.

  • Two existing bad loan collection and disposal agencies were consolidated into a new agency, the Resolution and Collection Corporation (RCC). The new RCC, which emerged from the Resolution and Collection Bank (RCB) and the Housing Loan Administration Corporation (HLAC), has expanded authority to purchase bad loans not only from failed banks but also from solvent institutions.


14. The FSA conducted special on-site inspections of major banks in the summer and fall of 1998 and of regional banks in the winter and spring of 1999. These inspections were more intensive than in the past and provided the authorities with roughly simultaneous evaluations of banks’ asset quality. Following the inspections, the FSA sent letters to banks, detailing its evaluation of each bank’s loan classification. Banks were required to respond within a month and encouraged to incorporate recommendations into subsequent loan classification exercises. The FSA’s policy is not to comment publicly on any individual bank (with the exception of nationalized banks), but the FSA retains the ability to use market pressure to encourage compliance, for example through frequent examinations, which would become known in the financial community.

15. The FSA found that both major banks and regional banks had understated their classified loans as of March 1998 (Table IV.4). The bulk of the FSA’s reclassifications—¥3.6 trillion out of ¥5.4 trillion for major banks, and ¥1.4 trillion out of ¥2.0 trillion for first-tier regional banks—was from Class 1 to Class 2, which implied little additional provisioning. For major banks, the reclassification of ¥1.6 trillion of Class 2 to Class 3 loans applied mainly to the banks that were subsequently nationalized. Similarly, the FSA found significant inadequacies in loan provisioning mainly in the nationalized banks. These results were not surprising, given that the FSA’s evaluation of the adequacy of loan classification and provisioning (LCP) was based on banks’ own criteria.

Table IV.4.

Japan: Financial Supervisory Agency’s Special Inspections

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Source: Financial Supervisory Agency

Classified loans are reported net of specific provisions.

16. A new inspection manual was issued in April 1999 and becomes effective in July. Although the purpose of the new manual is to primarily clarify—rather than strengthen—existing standards, its introduction will effectively tighten standards for those banks that had been exploiting loopholes. The new manual is not expected to have a large impact on loan loss provisioning in the aggregate.

17. Supervisory resources are being increased, which will allow for more frequent regular on-site inspections. The FSA’s budget for FY1999 provides for a one-half increase in staff, mostly inspectors. Although about 90 percent of current FSA staff are on secondment from other ministries, most are expected to remain at the FSA. The FSA’s current objective is to inspect all major banks and about half the regional banks every year, and the remainder of the regional banks (generally the stronger ones) every other year. In addition, special inspections will focus on particular issues, such as Y2K preparedness.

Nationalization of Major Banks

18. The new bank legislation and the special inspections prepared the ground for the temporary nationalization of two major banks. Following reports that the LTCB was having difficulties raising funds, the bank’s market valuation dropped sharply in June 1998, implying serious concerns about the solvency of the bank. The authorities’ initial plan—announced at the end of June—was to merge LTCB with the smaller Sumitomo Trust Bank, but this plan was eventually abandoned, in part because of Sumitomo Trust’s reluctance to take over LTCB’s substandard loans. The failure in September of Japan Leasing, one of LTCB’s main affiliates with more than ¥1.5 trillion in debts (including ¥256 billion owed to LTCB and ¥150 billion to Sumitomo Trust), left little doubt about LTCB’s own insolvency and contributed to the buildup of market pressures. After LTCB applied for nationalization on October 23, the Deposit Insurance Corporation (DIC) acquired all the outstanding shares and provided financial support, thus allowing LTCB to continue its regular operations and meet all of its obligations.

19. LTCB’s capital position turned out to be much worse than originally thought. LTCB reported a capital adequacy ratio of 10.3 percent for March 1998 and 6.3 percent for September 1998. At the time LTCB was nationalized in October, the FSA’s special inspection found that the bank had negative net worth as of end-September of ¥160 billion (about 0.9 percent of risk-weighted assets), including unrealized losses on securities holdings. In March 1999, the FRC declared that LTCB’s negative net worth as of October 1998 was in fact ¥2.5 trillion (14.4 percent of risk-weighted assets as of end-September). LTCB’s losses were borne in part by its former shareholders, as the share price for the nationalization was set at zero.

20. LTCB’s government-appointed management is currently seeking a buyer for the bank with the assistance of a foreign investment advisor. LTCB has started restructuring, with reductions in the number of employees and withdrawal from overseas operations, and is expected to transfer all of its bad assets to the RCC. However, LTCB’s better borrowers and better employees are—inevitably—leaving. While several investment groups have expressed interest in LTCB, the original goal of finding a buyer by the end of April was not met. Although the government would prefer to sell the bank as an ongoing business, most potential investors are reportedly more interested in either creating a bank specializing in loan collection or buying a pool of assets.

21. The authorities acted more swiftly with Nippon Credit Bank (NCB) following the FSA’s special inspection. During 1997–98, NCB had struggled through a series of attempts to restructure, including the complete withdrawal from overseas operations, cuts in the number of employees and salaries, and financial assistance from the BOJ and other commercial banks. The FSA notified NCB in November 1998 that, based on its special inspection, NCB had negative net worth as of March 1998. After NCB failed to develop an acceptable remedial action plan, and rejected the government’s request that it apply voluntarily for nationalization, the authorities put NCB under state control on December 14.

Public Capital Injections into Major Banks

22. The public capital injections in March 1999 amounted to ¥7.5 trillion, about four times the amount injected in March 1998 (Table IV.5).5 In contrast to last year, the bulk of the public funds were structured as convertible preferred stock, which—in principle—will give the authorities considerable leverage over banks that fail to perform. The average yields to be paid on the public funds are low—even lower than the interest rates on last year’s injections of subordinated debt—and little differentiated across banks. The injections were funded by the DIC, which raised ¥6.5 trillion from private financial institutions and borrowed the remainder from the Bank of Japan in the form of six-month loans.

Table IV.5.

Japan: Public Capital Injections, March 1999

(In billions of yen, unless otherwise specified)

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Source: Financial Revitalization Commission.

Some banks issued two tranches of convertible preferred shares, with different convertiblity dates. In these cases, the time to the first date is shown in this column.

23. The banks that applied for public funds were largely the same as those that received public money under the old recapitalization scheme in March 1998, the main exception being the Bank of Tokyo-Mitsubishi, which decided not to apply. In order to qualify for public funds, banks had to meet two criteria, like last year: positive net worth and ability to generate long-term profits, The standard for determining net worth was set slightly higher than in March 1998, as the FRC included in full unrealized losses on securities holdings and applied somewhat stricter provisioning standards for classified loans. Specifically, the FRC called for 70 percent coverage of the unsecured portion of Class 3 (doubtful) loans and 15 percent coverage of the unsecured portion of substandard Class 2 (special mention) loans. However, the base for the higher provisioning ratios was rather narrow—the unsecured portion of substandard loans was only about 10 percent of class 2 loans—so the net impact on provisioning was small compared to the magnitude of potential uncovered losses. Major banks made provisions of about ¥10 trillion in FY1998, about ¥3 trillion more than projected in November 1998.

24. To show long-term profitability, receiving banks submitted detailed restructuring plans (Table IV.6). These have four main components:

  • Expansion of profitable activities. Gross income is to be raised on average by about 3 percent over four years, through increasing housing loans and loans to small enterprises, expanding ATM networks and business hours, offering private banking services to wealthy clients, and selling investment trusts (mutual funds), While these efforts are clearly in the right direction, competition in retail banking is already fierce, with regional banks having large branch networks and finance companies dominating the technology-intensive consumer loan business. Also, to the extent that many major banks try to expand into similar types of activities, they are unlikely to all succeed in their goals, because profit margins in these activities will probably fall. More generally, it will be difficult to increase interest margins in view of the weak economy, not only for economic but also for political reasons. There is also the danger that banks will expand high-margin but risky activities, such as derivatives trading.

  • Cost reduction, which accounts for much of the projected improvement in net income. Operating expenses are projected to be reduced on average by about 8 percent over four years, mostly by cutting personnel costs. The number of bank branches is expected to decline, with a sharp reduction in overseas branches, though all but one major bank expect to remain internationally active. However, cost cutting may be less beneficial than widely assumed, as Japanese banks already have low costs compared to other international banks and need to spend more on upgrading information technology.6

  • Strategic alliances. Trust banks have been especially active, with Yasuda Trust becoming a subsidiary of Fuji Bank, and Mitsui Trust and Chuo Trust planning to merge in April 2000. Several looser tie-ups were also announced. However, some mergers across sectors (say between a bank and a life insurance company) will add little value, because they simply formalize existing cross-selling relationships within keiretsu groups.

  • Balance sheet adjustments. Banks are planning to increase package sales of distressed unsecured loans and loans secured by real estate, and some banks are planning to sell reduce their holdings of equities. However, the announced plans to sell equity holdings appear modest (¥100–200 billion per year for five years) and do not involve selling the shares of keiretsu members.

Table IV.6.

Japan: Major Banks’ Restructuring Plans, FY1998 to FY2002

(Percent changes)

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Source: Nikkei Weekly, Merril Lynch.

Change from FY1997 to FY2002.

25. In addition to their restructuring plans, banks applying for public funds agreed to obtain new capital from private sources (about ¥2 trillion) and to increase lending by ¥6.7 trillion in FY1999, with nearly half (about ¥3 trillion) earmarked for small and medium-sized businesses.

26. Major banks’ restructuring plans will be monitored through quarterly hearings and semi-annual reports in conjunction with financial statements.7 The FRC will take action if a restructuring plan is not being implemented or if a bank’s financial condition deteriorates sharply. The FRC’s first enforcement tool is an improvement order, which would be aimed at ensuring the implementation of a restructuring plan. The FRC’s ultimate enforcement tool is to convert its preferred shares into ordinary shares, which it is authorized to do if a bank’s capital adequacy ratio falls below 4 percent. If the government converts its holdings of preferred stock into common stock (at book values), it would gain majority stakes in three major banks and close to a majority stake in a fourth. The government could exercise its right to convert stock at these four banks as early as July 1999; conversion dates are longer—up to five years—for stronger banks. If banks’ operating environment deteriorates substantially, the FRC will likely consider injecting more public funds to support strengthened restructuring plans.

Regional Banks

27. The regulatory authorities began implementing the prompt corrective action (PCA) framework for domestic banks in April 1999 (international banks became subject to PCA in April 1998).8 On the basis of the FSA’s special inspections, three second-tier regional banks—Kofuku, Kokumin, and Tokyo Sowa—were declared insolvent and placed under government control. The authorities confirmed that all deposits would be fully protected and appointed receivers to manage the banks’ operations while buyers are sought. Receivership can last up to one year, though a bridge bank can take over before that, and the banks are expected to sell their bad loans to the RCC. Three more banks—first-tier Hokkaido Bank and Niigata Chuo Bank, and second-tier Namihaya Bank—have been ordered to increase their capital in order to meet the newly-effective 4 percent capital adequacy ratio for banks with only domestic operations.

28. The FRC recently announced guidelines for the injections of public funds into regional banks. The FRC will provide public funds to support either banks that are indispensable to a regional economy or consolidation among banks, including through mergers and alliances. While the precise criteria that will used to determine indispensability have not been announced, it is expected that a regional bank that provides 20–30 percent of the outstanding bank lending in a single prefecture could satisfy the requirement. The FRC also announced that regional banks applying for public funds will be required to raise their capital adequacy ratios to 8 percent, double the current 4 percent requirement for banks with domestic operations only.

Measures to Facilitate Debt Workouts and Bad Loan Disposal

29. The tax code was amended in June 1998 to facilitate debt workouts. Specifically, banks were permitted to deduct from their taxable income the losses incurred as a consequence of reaching out-of-court debt forgiveness agreements, and to allow debtors to offset the corresponding windfall gains against past and future losses. To benefit from such favorable tax treatment, the debt workout agreement must involve a comprehensive restructuring plan and be approved by all creditors. Partly as a result, major banks and life insurance companies forgave ¥1.9 trillion in debts in FY1998.

30. The October 1998 bank legislation gave a boost to bad loan disposal by legalizing private loan collection companies. Until then, only lawyers had been allowed to collect loans on behalf of financial institutions. Under the new law, private companies may not only collect loans on behalf of financial institutions but also buy collateralized loans from financial institutions and collect loans on their own account. Thus far, the Ministry of Justice has licensed four companies and expects to license about 30 by the end of summer.

31. Legislation enacted in June 1998 facilitated the creation of special purpose vehicles (SPVs). The new securitization law, which regulates securities backed by loans collateralized by real estate, enhances the SPV’s ability to secure claims on specific assets by creating a centralized system for registering secured interest in (or ownership of) specified financial assets. Under the new law, the original borrowers no longer need to be notified about the sales of their loans. Favorable tax treatment was also granted to SPVs and related transactions.

Implementation of Big Bang Reforms

32. The Big Bang financial reforms remain on schedule. Following the enactment of the Financial System Reform Law in June 1998, most remaining measures were implemented during the course of FY1998. Important changes in recent months include allowing banks to sell investment trusts (mutual funds), establishing investor protection schemes for the life insurance and securities industries, the abolition of the securities transaction tax, the market pricing of short-term government financing bills, and allowing finance companies to issue bonds to raise funds for lending.9 Three further reforms are scheduled to occur in October 1999: commercial banks will be allowed to issue straight bonds, restrictions on the stock brokerage business of banks’ securities subsidiaries will be lifted, and brokerage commissions will be fully liberalized. Cross-sectoral competition between banks and insurance companies will be allowed by March 2001.

33. Financial deregulation has expanded opportunities for foreign financial companies. The main developments over the past year include Merrill Lynch taking over the retail operations of failed Yamaichi Securities (previously, Japan’ fourth largest securities house); the Travelers Group buying a 25 percent stake in Nikko Securities and creating a joint venture called Nikko Salomon Smith Barney; and GE Capital acquiring the equipment and auto leasing business of Japan Leasing, which failed in September 1998. Foreign securities companies now handle more than one-third of the total trading volume on the Tokyo Stock Exchange, and are playing an increasing role in the surge in mergers and acquisitions (M&A) involving Japanese companies. Reflecting substantial fee income from M&A activity and other advisory services, foreign securities companies earned record profits in FY1998—four times the level of FY1996—in contrast to many Japanese securities companies, which have continued to make losses.

Life Insurance Companies

34. The performance of life insurance companies deteriorated further in FY1998, reflecting negative investment spreads and heavy provisions against NPLs.10 The gap between investment returns and the yield promised to policyholders for the eight largest insurers grew almost 10 percent from the previous year to ¥1.3 trillion. Record loan loss provisions of ¥800 billion were made by the eight largest companies. Declining confidence in the financial soundness of life insurance companies led to a 17 percent fall in sales of life insurance policies and a continued high rate of policy cancellations.

35. Toho Mutual Life Insurance Company—a mid-size insurer—was ordered to suspend operations in June 1999, the second such failure in two years and the first under the new prompt corrective action (PCA) procedures for life insurance companies. Toho’s negative net worth is estimated to be about ¥200 billion, well in excess of the ¥15 billion current reserves of the Policyholder Protection Fund. While the December 1998 government guarantee on the fund’s financing ensures that the technical reserves (i.e., contributions plus accumulated interest) of all life insurance policies will be fully covered until March 2001, holders of savings-type insurance policies may face a cut in benefits, as occurred with policyholders at Nissan Mutual Life. The remaining 15 large and mid-sized life insurance companies all satisfied the solvency margin requirement for end-March 1999. The FSA recently started inspections of the asset quality of all life insurance companies.

C. Remaining Challenges

Planned Removal of Blanket Deposit Insurance

36. The planned removal of blanket deposit insurance in 2001 has raised market concerns about whether banking system weaknesses will have been fully dealt with by that time. Given the magnitude of potential uncovered losses and the uncertainty about banks’ future profitability, the planned replacement of blanket with limited deposit insurance in April 2001 is already raising interest spreads on bank debentures with maturities greater than two years. While the prospect of market discipline could spur bank restructuring efforts, markets will begin anticipating liquidity problems well ahead of April 2001, so there is in fact little time for preemptive restructuring. In addition, the DIC may soon need to secure additional funds to protect depositors, as recent bank failures—especially of LTCB and NCB—are reported to have almost exhausted the original government bonds of ¥7.1 trillion granted by the government to the DIC.

37. The Financial System Council (FSC), an advisory body to the MOF, is discussing policy options to accompany the reintroduction of limited deposit insurance after March 2001. Items under discussion include the tools for resolving failed banks (the current tools expire in March 2001), the procedures for deposit payoffs, the possible adjustment of deposit insurance premia for the strength of a bank’s balance sheet and its profitability, the possible increase in the average level of deposit insurance premia (to restore the solvency of the DIC), and the possible extension of deposit insurance to bank debentures. In a recent interim report, the FSC proposed several policy options for resolving failed banks after March 2001, including the adoption of purchase and assumption operations, in which some or all of a failed bank’s assets are purchased and some or all of its liabilities assumed by a receiving bank (this method is commonly used by the Federal Deposit Insurance Corporation in the United States). The FSC intends to present detailed proposals by the end of 1999, and the government will prepare draft legislation based on the recommendations in early 2000.

Balance Sheet Weaknesses

38. Notwithstanding the improvement in supervision, the adequacy of bad loan recognition and provisioning, as well as bank capital more broadly, remain in question. Drawing on practices in other advanced countries, the authorities could take five steps to address these concerns:

  • Loan classification and provisioning standards could be made more stringent, including, for example, by setting a minimum provisioning ratio for class 2 loans.

  • Capital adequacy requirements could be strengthened, especially by limiting the use of tax deferred assets and increasing the minimal capital ratio for all banks to 8 percent.

  • Supervision could be further improved by increasing the FSA’s resources, to allow more frequent on-site inspections of troubled banks, and enhancing its autonomy, including an independent source of funding (such as levies on supervised institutions) and the authority to set its own salaries.11

  • Adequate provisioning could be encouraged through the automatic tax-deductibility of specific provisions consistent with loan classification standards, subject to future recapture if actual losses turn out to be less than expected.12

  • Disclosure standards could be strengthened by improving frequency, e.g., quarterly rather than semiannual reports, and depth, e.g., full disclosure of self assessments, including gross amounts of loans by asset class, the amounts covered by collateral or guarantees, and provisions.

Encouraging Restructuring

39. Major banks’ restructuring plans by themselves appear unlikely to restore core profitability. More aggressive action is likely to be needed in the areas of consolidation (to generate economies of scale, which are particularly important in the creation of new products and the development of new markets), securitization of corporate loan portfolios (to free up capital for more profitable lending), and the expansion of fee-based income (to increase revenues). Although the mergers announced so far are welcome, they do not substantially reduce the excess capacity in the banking system. The authorities could facilitate restructuring in three important ways:

  • The injection of any further public funds could be tied to a market test, such as the requirement to raise matching funds from private markets.

  • The early return of nationalized banks to the private sector could be encouraged, e.g., by allowing them to cease functioning as ongoing concerns while selling off their assets and liabilities.

  • Strategies to limit the competitive advantages of the public sector in financial intermediation could be considered.

Debt Workouts and Disposal of Bad Loans

40. While several debt workouts have been announced, more progress needs to be made. The tax code amendment allowing banks to deduct the losses incurred from reaching out-of-court debt restructuring agreements has encouraged debt forgiveness. Measures that could accelerate the pace of debt workouts include:

  • Establishing an arbitration council to mediate out-of-court debt workouts between creditors and debtors, especially in the real estate sector, in the spirit of the London approach.

  • Requiring that the recipients of public funds meet specific targets for the working out or disposal of debts.

  • Improving the effectiveness of corporate rehabilitation procedures, so as to give debtors more leverage in seeking out-of-court debt workouts.

41. The pace of bad loan disposal remains slow. Significant sales of loans and collateral are needed to introduce better value recognition and establish realistic floor prices for assets. The delay in this process is impeding restructuring in banks and nonfinancial corporations. The main obstacle to greater sales is inadequate recognition of bad loans, as disposal would force banks to realize additional losses. In addition to ensuring the full recognition of loan losses, the authorities could encourage the RCC to hold a steady stream of auctions of bad loans that it has acquired from failed financial institutions.

Reduced Public Sector Role in Financial Intermediation

42. The Big Bang reforms need to be complemented with steps to scale back the public sector’s role in financial intermediation. The long-term profitability of private sector financial intermediation (banks’ core business) is being squeezed both by more competitive and effective capital markets and by the public sector’s continuing important role in raising deposits and making loans. At present, around one third of private saving is channeled by the Postal Savings System through the Fiscal Investment and Loan Program (FILP) to fund government lending institutions, a system that lacks transparency and is likely to misallocate resources. The government has developed a blueprint for reforms which could end the automatic deposit of postal savings and pension contributions with the Trust Fund Bureau for investment through the FILP, allowing independent investment decisions by a corporatized postal savings system and requiring some FILP-funded agencies to raise funds directly on the market. Reforms in this area could go further in reducing the role of the FILP and curbing the privileged position of the Postal Savings System, especially given the diminishing importance of post offices as providers of essential financial services to outlying areas (see Kuwayama, 1999).13


  • Atkinson, David, David Richards, and Tomishi Ishida, “Bank Cost Cutting: No Better Reason to Sell,” Goldman Sachs Investment Research Report on Japanese Banks, February 1999.

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  • Kuwayama, Patricia Hagan, “Postal Banking in the United States and Japan: A Comparative Analysis,” Bank of Japan, Institute for Monetary and Economic Studies, Discussion Paper No. 99-E-17, June 1999.

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


Prepared by James Morsink (ext. 37875).


Also starting in March 1999, most banks began to include loans to bankrupt or potentially bankrupt borrowers on which interest was not yet overdue.


Banks were allowed to adopt the deferred tax accounting method for their unconsolidated accounts for their FY98 financial statements (this method was already used for consolidated accounts). The adoption of this method increased parent banks’ equity capital (this year only) by the amount of deferred tax receivables that they carried. There was no effect on capital adequacy ratios, because these were already calculated on a consolidated basis.


A bridge bank is a bank under state administration that is expected to be sold back to the private sector.


In addition, during FY98 banks raised about ¥2.8 trillion in Tier-1 capital from private sources, mostly related companies: about ¥1.4 trillion in common shares and about the same amount in higher yielding preferred securities.


For example, Sanwa Bank as a whole reportedly spends less on information technology than the Tokyo office of Goldman Sachs.


Following hearings conducted at end-June, the FSA announced that major banks were implementing their restructuring plans as scheduled.


For details of the PCA framework, see the 1998 Japan Selected Issues paper (IMF Staff Country Report No. 98/113).


Hitherto, nonbanks were allowed to use funds raised through bonds for capital investment, but had to raise loan money through bank borrowing or equity financing. The right to issue bonds to raise loan money will be limited to nonbanks capitalized at over ¥1 billion, and they will have to meet the same standards of bad loan disclosure as banks. This change is expected to benefit large nonbanks engaged in mortgage lending, consumer lending, and leasing.


For background, see Chapter V on Financial Sector Reforms in the 1998 Selected Issues paper (IMF Staff Country Report No. 98/113).


Improved supervision is especially important in light of the Big Bang financial reforms that expand banks’ range of activities.


The recent tax change allowing banks deduct debt forgiveness did not address the deductibility of provisions. Currently, provisions are automatically deductible only under certain narrow circumstances; otherwise, tax deductibility depends on specific rulings by the tax authorities.


One possibility would be to restructure the Postal Savings System as a “narrow bank,” whose services are priced to fully reflect costs and risks incurred.