Abstract
A sustained decline in fertility rates underlies a rapid aging and decline of Japan's population. This will have profound social and economic implications. The paper illustrates the difficult situation facing Japanese fiscal policy in the years ahead. The findings of this paper indicate that there may be a role for foreign exchange interventions in providing stimulus at the current conjuncture. Deposit insurance reform is a central element in the government strategy to strengthen the Japanese banking system. The unemployment-deflation puzzle in Japan has been explained.
IV. Deposit Insurance Reform
by James Morsink
A. Introduction
1. Deposit insurance reform is a central element in the authorities’ strategy to strengthen the Japanese banking system. While blanket deposit insurance has been helpful in containing systemic strains during recent difficult years, the re-imposition of limited deposit insurance coverage is critical to enhancing market discipline and reducing moral hazard in the future, thus decreasing the risk of a recurrence of systemic banking problems. Moreover, the prospect of limited coverage has complemented the authorities’ broader efforts to strengthen the supervisory and regulatory framework, and is thus reinforcing the pressure on banks to speed up their restructuring efforts.
2. International experience points to three conditions that are critical for a robust system of limited deposit insurance:
Market discipline by large depositors and creditors. Successful systems of limited deposit insurance expose creditors and large depositors to risk, and thereby provide the incentives for them to monitor the condition of their bank. For the risk of bearing losses to be credible, resolution methods for dealing with failed banks must be well-understood and the authorities must be prepared to use them. To minimize the burden on the taxpayer, resolution tools need to be endowed with flexibility and speed, while aiming at least-cost solutions.
A strong regulatory and supervisory framework. To protect the deposit insurance fund and to limit systemic risks, troubled banks need to be identified at an early stage and their problems addressed expeditiously, preferably well before a weak bank becomes insolvent. Key elements of such a framework include strong capital adequacy standards and a well-funded and well-staffed supervisory agency.
Depository institutions that are basically sound. The banking system as a whole, including smaller financial institutions, needs to be sufficiently strong to withstand the removal of the blanket guarantee and the associated increase in market discipline. It is also important that the banking system be perceived as basically sound.
3. After a background section, the remainder of this chapter addresses each of these issues in turn. The discussion draws lessons from international experience in general and recent U.S. experience in particular, since the present U.S. system seems to offer the closest parallel to the approaches being introduced by the Japanese authorities.
B. Background1
4. While Japan established an explicit deposit insurance system in 1971, the deposit insurance fund has never been used to pay off depositors of a failed bank.2 The original mandate of the Deposit Insurance Corporation (DIC) was limited to collecting insurance premia and paying off insured depositors of failed institutions.3 Thus, unlike the U.S. Federal Deposit Insurance Corporation, the DIC of Japan was not expected to play an active role in the resolution of distressed financial institutions. Even with this limited mandate, the DIC’s funding was low by international standards.4 Moreover, no formal guidelines for the suspension of a bank’s operations existed until recently, and there were no separate insolvency procedures for banks until 1998. Finally, resort to the bankruptcy process would have automatically resulted in deposit payoffs, an outcome that is generally less favorable than the wide variety of possible purchase and assumption (P&A) transactions.5
5. Until the 1990s, the process for managing bank failures was in practice largely ad hoc. Using its branch licensing authority, the Ministry of Finance (MOF) encouraged stronger banks to absorb insolvent institutions through what amounted to informal, administratively-orchestrated, whole-bank P&A transactions.6 In addition, at times the Bank of Japan (BOJ) provided loans to distressed banks in order to prevent systemic crises. This regulatory approach to bank failure was sometimes referred to as the “convoy system.” The informal framework was supported by the practice of limited disclosure, high barriers to entry, no failures (other than through mergers), and implicit full deposit insurance coverage. The concentration of information in the hands of MOF regulators and stronger banks, which monitored weaker banks, greatly limited the role of market discipline. Ueda (1996) noted that “the most important safety-net system in our country has not been the deposit insurance system, but the public’s confidence in the MOF and BOJ’s ability to avoid a major instability in the financial system.”
6. This implicit blanket deposit protection had some advantages in an economy dominated by bank finance and bank-led corporate governance. As banks held considerable borrower-specific information that could not be transferred costlessly to other lenders, bank failure would jeopardize these valuable economic relationships. At the same time, high entry barriers increased the value of a bank charter, which may have helped to constrain excessive risk taking. The informal system functioned well in a favorable economic environment and gained credibility from the stable political and bureaucratic structures.
7. The collapse of asset prices in the early 1990s undermined this informal system for protecting depositors and dealing with troubled banks. The declines in asset prices implied substantial losses for banks, which held large portfolios of stocks and relied mostly on real estate collateral to back up their loans, while the ensuing recession undermined borrowers’ ability to service their loans. As a result, regulators found it increasingly difficult to persuade banks to provide assistance to other banks, because even relatively strong banks faced serious bad loan problems. In addition, a 1993 amendment to the Commercial Code made bank managers personally liable for the misuse of shareholder funds.
8. Given the reluctance of banks to help each other out, the authorities began to use public funds in the resolution of troubled banks. Starting in 1992, the authorities made greater use of DIC funds to promote mergers among troubled credit cooperatives, nonprofit cooperative banks, and regional banks. In 1996, the authorities reorganized the Tokyo Kyodo Bank—established in 1995 to dispose of the assets of failed credit cooperatives—into a subsidiary of the DIC called the Resolution and Collection Bank (RCB), with its liabilities guaranteed and losses compensated by the DIC. Also in 1996, the Diet approved the use of public funds for resolving the jusen (home mortgage lending companies).7 While the amount of public funds was relatively small (¥680 billion or $6.2 billion), many observers regarded the protection afforded to some of the jusen creditors as nontransparent and unfair.
9. The public outcry forced the government to start putting in place more transparent and formal processes to govern bank failure and depositor protection. Legislation enacted in 1996 and 1997 provided for the introduction of prompt corrective action starting in 1998, which—by specifying supervisory actions that had to be taken at various capital ratios—decreased regulatory discretion in dealing with troubled banks, and for the establishment of an independent Financial Supervisory Agency (FSA) in June 1998. Another law gave regulators for the first time the authority to initiate corporate reorganization or bankruptcy procedures for financial institutions, which allowed a more timely handling of troubled banks.
10. At the same time, to reduce the risk of a banking crisis during the development of the new framework, the government made explicit the blanket deposit guarantee. Legislation enacted in 1996 raised deposit insurance premia from 0.012 percent to 0.084 percent (including a special premium) and provided a government guarantee to the DIC to borrow up to ¥2 trillion from the BOJ or private financial institutions through the Special Account for Credit Cooperatives through March 2001. Moreover, all credit cooperative deposits, including those beyond the insurance payment limit of ¥10 million, were explicitly insured for this period. Notwithstanding the fact that this government guarantee strictly applied to only credit cooperatives, the authorities stressed that all bank deposits would be protected until March 2001. At the same time, a temporary exception to the payoff cost limit (the hypothetical cost of paying off depositors) for DIC financial assistance was made.
11. Despite the effective blanket guarantee, Japan suffered a financial crisis in late 1997 and 1998, which was the final blow to the informal “convoy system.” In contrast to the support offered to Hokkaido Takushoku Bank and Nippon Credit Bank in the first half of 1997, major shareholders and firms associated with failing financial institutions in late 1997—including Hokkaido Takushoku Bank, Yamaichi Securities, and Sanyo Securities—refused to come to their aid. Moreover, relatively strong, unaffiliated institutions resisted attempts to be drawn into rescue mergers.
12. In response to the financial crisis, legislation was enacted in 1998 that improved the framework and the amount of public funds available for bank resolutions. The deposit insurance system was strengthened by the authorization of ¥17 trillion for depositor protection (¥7 trillion in the form of government grants and ¥10 trillion as loan guarantees), an increase in DIC staff to almost 300 (compared to fewer than 10 until the early 1990s), and enhanced capacity to collect bad loans (with the creation of a committee to investigate civil and criminal liability in connection with bank failures). At the same time, ¥43 trillion of public funds were authorized for recapitalizing weak but solvent banks and nationalization of very weak banks. The legislation also established a high level body (the Financial Reconstruction Commission) to oversee banking system stability and restructuring, consolidated the two existing bad loan collection and disposal agencies (the RCB and the HLAC) into a new agency (the Resolution and Collection Corporation, RCC), and introduced a new tool—bridge banks—to deal with failed banks.8
13. While the broad framework for resolving banking problems helped to put an end to the financial crisis in early 1999, the banking system was not considered sufficiently sound to proceed with the reintroduction of limited deposit insurance as originally planned in April 2001. In particular, some smaller deposit-taking institutions, including some cooperative-type financial institutions, were not considered to be sufficiently strong. At the same time, the authorities took the view that deposits used for immediate living expenses and business operations should be protected until speedy resolution methods were well-established and a variety of private payments services introduced.9 As a result, the government decided in late 1999 to extend blanket deposit insurance for an additional year (until March 2002) and full protection for liquid deposits until March 200310.
C. Design of Limited Deposit Insurance and Bank Resolution Tools
14. The recently-enacted deposit insurance system and associated bank resolution tools provide many of the right incentives and instruments to keep the financial system sound, the potential for cost-minimizing bank resolutions, and an escape clause in cases of systemic crisis.
Limited Deposit Insurance
15. After April 2003, deposit insurance coverage in Japan will be subject to credible limits, which will help to curb moral hazard and promote market discipline. The level of coverage (¥10 million) is about two and a half times GDP per capita, about average for G7 countries (Table IV.1). Coverage is per depositor rather than per deposit. All private deposit-taking institutions, whose head offices are located in Japan, are required to participate in the system, and no non-deposit-taking institution may participate. As in other G7 countries, interbank deposits are not covered, so as to promote monitoring by large depositors. The new legislation establishes procedures for paying off insured deposits, including information on multiple deposits at a single bank (so as to enforce the maximum limit on deposit insurance coverage), though the efficiency and speed of these procedures have not yet been tested. However, the full protection of liquid deposits between April 2002 and March 2003 perpetuates moral hazard, especially as such deposits are difficult to demarcate from other deposits.11
G7 Countries: Ratio of Deposit Coverage to Per Capita GDP, 1999
From Garcia (1999) using average 1999 exchange rates.
From World Economic Outlook.
G7 Countries: Ratio of Deposit Coverage to Per Capita GDP, 1999
| Coverage 1/ | GDP per capita 2/ | Ratio of deposit Coverage | |
|---|---|---|---|
| (In U.S. dollars) | |||
| Canada | 40,385 | 20,874 | 1.9 |
| France | 64,968 | 24,594 | 2.6 |
| Germany | 21,790 | 25,782 | 0.8 |
| Italy | 122,310 | 20,734 | 5.9 |
| Japan | 87,789 | 34,402 | 2.6 |
| United Kingdom | 32,364 | 24,633 | 1.3 |
| United States | 100,000 | 33,934 | 2.9 |
| Average (unweighted) | 67,087 | 26,422 | 2.6 |
From Garcia (1999) using average 1999 exchange rates.
From World Economic Outlook.
G7 Countries: Ratio of Deposit Coverage to Per Capita GDP, 1999
| Coverage 1/ | GDP per capita 2/ | Ratio of deposit Coverage | |
|---|---|---|---|
| (In U.S. dollars) | |||
| Canada | 40,385 | 20,874 | 1.9 |
| France | 64,968 | 24,594 | 2.6 |
| Germany | 21,790 | 25,782 | 0.8 |
| Italy | 122,310 | 20,734 | 5.9 |
| Japan | 87,789 | 34,402 | 2.6 |
| United Kingdom | 32,364 | 24,633 | 1.3 |
| United States | 100,000 | 33,934 | 2.9 |
| Average (unweighted) | 67,087 | 26,422 | 2.6 |
From Garcia (1999) using average 1999 exchange rates.
From World Economic Outlook.
16. A target level for the deposit insurance fund has not been established.12 Adequate funding of the deposit insurance system is essential to avoid the temptation to engage in regulatory forbearance. For example, in the savings and loan crisis in the U.S., the inadequate funding of deposit insurance was partly responsible for the delay in resolving troubled institutions. In Japan, the government recently granted a further ¥6 trillion to the DIC (in addition to the ¥7 trillion grant approved in 1998), but this may not be enough to deal with past problems, let alone provide an adequate cushion for future ones. One mechanism to ensure financial viability would be to set a target level for the deposit insurance fund, usually expressed as a percentage of insured deposits, based on forecasts of the fund’s income and expenses, including outlays to compensate depositors of failed banks.13 The target would then provide an indication of how much recapitalization of the deposit insurance fund is needed—both to address past problems and ensure an adequate cushion for future problems—and of the deposit insurance premia that need to be set.14
17. While the deposit insurance function is separate from bank supervision and the lender of last resort, further steps could be taken to assure the independence of the DIC. Ideally, the organizational structure of a deposit insurance system provides independence from political interference and industry domination, while ensuring accountability. In Japan, the DIC is a special juridical entity, with its Governor appointed by the government and its Policy Board dominated by representatives of the banking industry. The independence of the DIC could be increased by having the chairman and majority of the Policy Board consist of worthy members of the public with no current ties to the banking industry, while bankers’ valuable experience could be utilized through their presence on an advisory board.
18. The DIC’s ability to protect the interests of depositors and taxpayers could be strengthened by giving it some back-up supervisory powers. In any deposit insurance system, a balance needs to be struck between the danger of inappropriate forbearance by the supervisor on the one hand, and the deposit insurance agency’s potential over-eagerness to close troubled banks to safeguard its own resources on the other. Some countries have resolved this conflict of interest informally, while others—such as the United States—have legislated formal back-up powers for the deposit insurance agency to be present at the on-site inspections of troubled banks, and to publicly revoke the deposit insurance of a bank it deems to be nonviable (which is equivalent to closing a bank).
Bank Resolution Tools
19. The new legislation improves the flexibility and speed of bank resolution tools. To avoid prolonged periods of public administration, which would be likely to substantially erode a failed bank’s franchise value, the legal procedures for business transfers have been simplified and expedited, while ex post procedures have been introduced to protect creditors in such transfers. At the same time, the flexibility of bank resolution methods has been enhanced by allowing the DIC to provide financial assistance in a wider variety of P&A operations. The success of the new procedures will depend on early starts to the process of preparing for the resolution of a troubled bank (so that a purchaser is ready by the time the bank is actually closed) and openness to using P&A operations that involve sales of asset pools to different investors, rather than insisting on preserving the bank as a going concern, which in many cases is not likely to be the least cost solution.
20. The new legislation also provides for loss-sharing arrangements. Loss-sharing arrangements are a key vehicle for keeping the management of a failed bank’s loans in the private sector, while ensuring a speedy resolution process, by protecting the purchaser of the bad loans from excessive downside risk. In Japan, the repurchase agreement in the recent sale of nationalized LTCB was an important step towards loss sharing arrangements. However, the nature of the agreement—under which for three years the DIC will bear the loss on any existing loan that is greater than 20 percent of book value (net of reserves)—would not appear to give the new owners of LTCB (now renamed Shinsei Bank) the right incentive once the loss approached 20 percent.15 It might be more effective to allocate a fraction (say 20 percent) of any loss to the purchaser, as is the practice in the United States, so as to ensure that the purchaser continues to share in the downside risk from poor collections on bad loans. More generally, the usefulness of loss-sharing arrangements will depend on tailoring them to individual banks’ circumstances and providing appropriate incentives to maximize the value of the assets. At the same time, more extensive use of loss-sharing arrangements will allow for a smaller public-sector role in managing bad assets.16
21. The systemic risk exception in Japan is similar to that in other countries, but the criterion guiding bank resolutions in normal times falls short of the least-cost principle. In cases of systemic risk, a Cabinet-level council headed by the Prime Minister will have the authority to reinstitute a blanket deposit guarantee, make wide ranging capital injections into banks, and/or nationalize failing banks.17 In normal times, the cost of the chosen bank resolution option must be less than the cost of a deposit payoff, which is a less demanding criterion than the least-cost principle required under U.S. law, which helps to minimize the burden on the taxpayer and encourage market discipline by large depositors.18
D. Addressing Remaining Bank Weaknesses
22. To ensure that deposit-taking institutions are sufficiently strong to withstand the increase in market discipline associated with removing the blanket deposit guarantee, further efforts are needed to ensure bank soundness. Under the new framework, the incentives facing large depositors and creditors will be very different from those at present. Once deposit insurance is limited, uninsured deposits will be much more prone to run from banks that are perceived to be weak, which could spread to other financial institutions that are perceived to face similar weaknesses.
To reduce the risks of further systemic shocks once limited deposit insurance is reintroduced, the regulatory and supervisory framework could be strengthened. In particular, disclosure standards in Japan still fall short of international best practice in terms of breadth and frequency.19 While important progress has been made in loan loss provisioning, concerns remain that the full extent of the bad loan problem has not yet been recognized. Similarly, in the area of on-site inspections, much has been accomplished, but further efforts and resources are needed to ensure adequate frequency, thoroughness, and sophistication. Finally, Japanese banks with exclusively domestic operations are required to hold only 4 percent capital, which does not provide an adequate cushion against adverse shocks or inadequate bad loan recognition.
Most banks have made important strides in recognizing bad loans while taking advantage of public capital injections to strengthen their capital base. Moreover, the weakest banks have now been identified and intervened, using the new resolution tools created in the 1998 banking legislation. As a result, the remaining banks now seem to be more stable, as reflected in market indicators such as the Japan premium. However, core profitability remains low. It is not clear how the recently-announced mergers among major banks will substantially raise profitability and create globally competitive financial institutions. Restructuring in regional banks is still at an early stage.
Important vulnerabilities remain among smaller regional banks and cooperative-type institutions, which hold about 30 percent of deposits. Credit cooperatives are only now beginning to be inspected by the FSA. While each individual institution is small, a generalized loss of confidence could have systemic effects.
23. Based on recent experience in other countries, an official assessment that the financial system is basically sound would help to ensure a smooth transition to limited deposit insurance (Garcia, 2000). For example, prior to the removal of the blanket deposit guarantee in Sweden in 1996, the Swedish government prepared an assessment of banking system soundness that was presented to the Swedish parliament and made public more than seven months before the planned removal of the blanket guarantee.20
References
Deposit Insurance Corporation of Japan Annual Report 1998 (April 1998-March 1999), DIC, October 1999.
Federal Deposit Insurance Corporation Resolutions Handbook: Methods for Resolving Troubled Financial Institutions in the United States, FDIC, 1998.
Garcia, Gillian G.H., “Deposit Insurance: A Survey of Actual and Best Practices,” IMF Working Paper WP/99/54, April 1999.
Garcia, Gillian G.H., “Deposit Insurance and Crisis Management,” IMF Working Paper WP/00/57, March 2000.
Milhaupt, Curtis J., “Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?” Bank of Japan, Monetary and Economic Studies, August 1999.
Ueda, Kazuo, “Causes of the Japanese Banking Instability in the 1990s,” University of Tokyo Faculty of Economics Discussion Paper Series No. 96-F-17, 1996.
This section draws heavily on Milhaupt (1999).
The statutory payoff limit was initially set at ¥1 million, increased in 1974 to ¥3 million, and rose in 1986 to ¥10 million, the current level. A second deposit insurance system, covering agricultural and fishery cooperatives, was established in 1973.
A 1986 amendment to the Deposit Insurance Law allowed the DIC to provide financial assistance in connection with mergers of troubled banks. However, the amount of assistance was limited to the hypothetical cost of paying off depositors. The cost of resolving troubled institutions usually exceeded this ceiling, so mergers continued to take place outside the formal deposit protection system.
For example, the ratio of insurance fund reserves to covered deposits in Japan was only 0.07 percent in 1995, compared to 1.30 percent in the United States.
In a purchase and assumption transaction, the acquiring bank purchases some or all of the failed bank’s assets and assumes some or all of the failed bank’s liabilities.
Branch growth constituted the principal form of competition between city banks under the regulated interest rate regime.
Another resolution company, the Housing Loan Administration Corporation (HLAC) was established to handle the remaining jusen assets.
A bridge bank is a bank under temporary state administration, which gives the authorities time to find a suitable private buyer.
Reflecting the history of blanket deposit insurance and no bank failure in Japan, many depositors are not presently accustomed to assessing the creditworthiness of their banks, and the authorities are not used to conducting rapid bank resolutions.
Liquid deposits are defined as those with interest rates of zero or close to zero, and include checking and savings deposits, but not time deposits or certificates of deposit.
Banks might be able to provide full protection for a wider range of deposits, by periodically sweeping non-liquid deposits into liquid deposits (sweep accounts are common in other countries). One solution would be to offer a system of coinsurance for the amount above ¥10 million. In other words, depositors would face the possibility of losing a small fraction (say 10 percent) of the covered deposit, which could help alleviate moral hazard while limiting the amount of loss.
The special deposit insurance premium (0.036 percent) will be eliminated in April 2003, reducing the premium to 0.048 percent.
Setting an appropriate target would require a realistic assessment of the condition of the banking industry, the size and timing of financial demands that are likely to be placed on the fund, and the industry’s ability to pay the necessary premia without prejudicing its profitability, solvency, and liquidity. In the United States, the target level is 1.25 percent of insured deposits and the actual level currently exceeds the target level.
In Japan, deposit insurance premia are not adjusted for bank risk. While risk-adjusted criteria could play a role in controlling moral hazard, in practice it is difficult to measure risk. In the United States, the additional premium for weak banks has been kept quite low in part because of concerns about the impact on these banks’ financial condition.
Indeed, Shinsei Bank recently sold its claims on Sogo, a troubled major retailer, to the DIC for their full face value (net of specific loan loss reserves).
International experience suggests that most bad assets should be managed by the private sector—either in the receiving bank or in specialized loan collection vehicles—so as to maximize their value, especially once the economic recovery is underway. In Japan, the RCC acts primarily as a collection agency, rather than trying actively to dispose of its bad assets.
In the U.S. under FDICIA, the Secretary of the Treasury—after consulting with the President and with the recommendation of the FDIC and Federal Reserve System—may grant an exception to the least-cost requirement in case of systemic risk.
The payoff cost principle provides more flexibility in dealing with a banking crisis.
Specifically, standards could require the disclosure of the results of stress tests using the banks’ internal risk assessment model; the full disclosure of the self-assessments of asset quality, including gross amounts of loans by asset class, the amounts covered by collateral or guarantees, and provisions; and quarterly—rather than semiannual—disclosure.
The Swedish government’s report was thorough, covering the banking system as a whole, categories of banks, and selected individual banks, and considered a wide range of indicators, including problem assets, loan losses, capital adequacy, profitability, and fund raising premia. The report took into account not only the views of the financial supervisory authority, but also those of banks themselves and of external observers, such as credit rating agencies. The report was far reaching, in that it considered the macroeconomic outlook and prospects for the real estate market, and evaluated the banking system’s prospects under different interest rate and asset price scenarios. Finally, the report was candid in recognizing remaining problems, including at individual institutions-these problems were considered manageable.