The Japanese economy is vulnerable to external and domestic shocks. The new government has made a commitment to turn the fiscal situation around. The new policy framework provides the Bank of Japan with the scope to ease the policy stance. A deteriorating macroeconomic environment has exposed underlying structural problems in the banking sector. Over the past year, Japan maintained its traditional emphasis on pursuing further trade liberalization through the World Trade Organization (WTO) framework, while at the same time initiating talks on bilateral free trade agreements.


The Japanese economy is vulnerable to external and domestic shocks. The new government has made a commitment to turn the fiscal situation around. The new policy framework provides the Bank of Japan with the scope to ease the policy stance. A deteriorating macroeconomic environment has exposed underlying structural problems in the banking sector. Over the past year, Japan maintained its traditional emphasis on pursuing further trade liberalization through the World Trade Organization (WTO) framework, while at the same time initiating talks on bilateral free trade agreements.

IV. Financial System Issues1

1. After a period of relative calm following the last round of public capital injections in 1999, a deteriorating macroeconomic environment has again exposed underlying structural problems in the banking sector. Notwithstanding some progress in restructuring banking operations and raising profitability, including in the context of large mergers, reported problem loans have remained high and concerns about asset quality remain. In early 2001, a sharp drop in the stock market reinforced concerns over bank capitalization, prompting the government to announce an emergency package aimed at disposing of major banks’ bad loans and reducing their exposure to equity market risk. Details relating to the measures in the package were specified in a policy blueprint announced by the Council for Economic and Fiscal Policy (CEFP) in mid-June 2001. Looking ahead, the introduction of mark-to-market accounting in FY2001 and the shift from blanket to partial deposit insurance in April 2002 could present formidable challenges for weaker banks, including some regional institutions and credit cooperatives.2

2. The life insurance sector has also been adversely affected by the economic slowdown, which brought deteriorating revenues, asset quality, and yield spreads during the past year. The major insurance companies have held up reasonably well so far, but a string of failures among mid-sized insurance companies has highlighted the increasing vulnerability of the sector. Entry by banks and the opening of some parts of the industry to cross-sectoral competition—concluding the Big Bang reforms—will raise competitive pressures over time and has already led to greater cooperation through mergers and alliances. Going forward, further consolidation is likely to occur.

A. Bank Vulnerability

3. Three years after Japan’s banking crisis, initial hopes that bank restructuring supported by public capital injections would restore banks to financial health have yet to be realized. Major banks, regional banks, and credit cooperatives continue to be burdened by sizable problem loans. In the view of the Financial Services Agency (FSA), Japan’s financial supervising agency, banks have adequately provisioned against nonperforming loans (NPLs), but some private analysts estimate that banks’ uncovered loan loss exposure remains excessively large—equivalent in the aggregate to half of Tier-1 capital for major banks and more than 100 percent of Tier-1 capital for regional banks. Analysts have also raised concerns about the quality of regulatory capital and low bank profitability. Banks also remain highly exposed to market volatility owing to their large equity and government bond holdings. Market fluctuations will directly affect bank capital with the introduction of mark-to-market accounting, effectively from September 2001, the first reporting period under the new regulations.

The Bad Loan Problem

4. Despite banks’ continued efforts to write off NPLs in FY2000, outstanding problem loans rose slightly as new NPLs emerged faster than expected. Banks recognized an estimated ¥5-6 trillion in fresh bad loans amid high-profile corporate failures and a sharp increase in bankruptcies among smaller companies. Banks also participated in several large-scale debt forgiveness packages and had to cover falling collateral values as land prices continued to decline. Moreover, progress in the implementation of loan classification standards has also contributed to the need for additional provisioning. As a result of these factors, loan loss charges for major banks amounted to ¥4.3 trillion for the past financial year—2.6 times initial estimates and comparable to credit costs in the previous year.

5. As of September 2000, gross NPLs for major and regional banks according to the Financial Reconstruction Law (FRL) standard amounted to ¥32 trillion, compared to ¥11-12 trillion in general and specific reserves and an undisclosed amount of collateral (Table IV.1).3 A large amount of loans which were lent to borrowers classified as “needing attention” may be at risk of becoming nonperforming, however recently released data—based on banks’ self-assessment of asset quality—show that the total face value of loans by major and regional banks to borrowers whose financial condition requires attention or who are either bankrupt or close to bankruptcy amounts to ¥111 trillion, of which ¥48 trillion is covered by “superior” collateral (Table IV.2). The remaining ¥63 trillion is either covered by “ordinary” collateral or unsecured.4 Once credit cooperatives are included (using data as of March 2000), the total value of loans to classified borrowers rises to ¥151 trillion (30 percent of GDP), of which ¥70 trillion is covered by superior collateral.5

Table IV.1.

Japan: Problem Loans

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Source: Financial Services Agency, FitchIBCA, and staff calculations.

Under the self-assessment standard, banks report all loans to borrowers in or near bankruptcy or in need of attention, with the exception of class I loans (which are covered by superior collateral).

The FRL standard requires banks to report all loans to bankrupt or nearly bankrupt borrowers, as well as loans to borrowers requiring special attention, notwithstanding the quality of collateral.

The standard used by the Federation of Bankers’ Associations (FBA), which has been longest in use, is somewhat narrower than the FRL standard. It does not include guarantees, foreign currency assets, and other claims.

Relative to nonperforming loans according to the FBA standard.

Table IV.2.

Japan: Classification of Bank Loans

(in trillions of yen)

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Source: Financial Services Agency, April 2001.

Class 1 loans include all loans to normal borrowers, as well as other loans that are covered by superior collateral or guarantees. Class 2 loans include all remaining loans to borrowers requiring attention, as well as loans to borrowers in or in danger of bankruptcy that are covered by ordinary collateral. Class 3 loans include all remaining loans to borrowers in danger of bankruptcy, as well as remaining loans to bankrupt borrowers with doubtful recovery value. Class 4 loans are regarded as unrecoverable.

The nonperforming loans are slightly larger than reported in Table IV.1, owing to differences in coverage and loan reclassification in between publication dates.

6. Notwithstanding concerns that have been raised over the large amount of potential problem loans, the FSA takes the view that currently performing loans to borrowers requiring attention are a source of income for the banks and pose manageable risks. The FSA has advised banks to adjust lending policies and conditions according to the credit risk of the borrower, and they see banks as having made progress in this area. In addition, the FSA has expressed confidence that banks are well advanced in strengthening loan classification and provisioning practices to internationally-comparable levels, citing endorsements by external auditing firms that regard banks’ accounting practices as adequate. Following intensive on-site examinations for all major and regional banks, the FSA has reported increasing compliance with its 1999 bank inspection manual, which closely mirrors supervisory practices in other major industrial countries. Moreover, the FSA enforces stringent provisioning requirements for non-performing loans, with latest data showing that major banks’ loans to special attention borrowers are more than 50 percent covered by either collateral, loan guarantees or loan loss provisions. Loans to borrowers in danger of bankruptcy show coverage in excess of 80 percent, and loans to bankrupt borrowers are fully covered.

7. The FSA does not see a need for a further tightening of classification or provisioning standards. In particular, it believes that forward-looking provisioning—beyond the level consistent with historical loss rates—would be inconsistent with international accounting standards and practices, and could exacerbate the already pro-cyclical tendency of bank lending activities. Moreover, the FSA is concerned that overly conservative provisioning could lead to an excessive reduction of profits and thus result in an infringement of shareholder interests. It also argues that provisioning should adhere to the Commercial Law and generally accepted accounting practices. Nevertheless, the FSA plans to continue efforts to ensure strict enforcement of existing standards and the strengthening of banks’ risk management capabilities in the context of future examinations.

8. By contrast, market analysts consider that the banking system is substantially underprovisioned against potential loan losses. Using various methods, different analysts estimate that major and regional banks need to incur an additional ¥20–30 trillion (5–6 percent of GDP) in additional loan loss charges to reach adequate provisioning levels (Box VI.1). These charges compare to total Tier-1 capital of ¥33 trillion. The basis for this assessment is their view that (1) the average loan-loss rate on existing NPLs may prove to be higher than the present rate of provisioning, and (2) a substantial amount of so-called “gray-zone” loans—loans to borrowers requiring attention that have not yet been classified as NPLs—may become nonperforming and incur losses.

  • Loss rate on reported NPLs. On the basis of the loss rate on loans that have already been fully removed from banks’ balance sheets, analysts expect loss rates for existing NPLs to exceed provisioning requirements on the non-collateralized part of NPLs, which are between 15 and 70 percent, depending on the classification of the borrower.6 Moreover, notwithstanding a 30 percent haircut on collateral values imposed by the FSA, analysts consider that the value of collateral on bank balance sheets is often overstated: write-offs of land values have not kept up with the decline in land prices, and sales typically occur at depressed prices, owing to the absence of a liquid real estate market. Analysts estimate that these factors could give rise to further losses of ¥10–20 trillion on existing NPLs.

  • Losses on gray zone loans, In addition to reported NPLs, analysts expect substantial losses from “gray zone” loans. These loans are typically owed by severely indebted companies concentrated in some of the weakest sectors of the economy (real estate, construction, retail, financial and other services), many of which would not be able to survive if interest rates rose significantly from their present low levels. Loans to such companies account for more than half of all major bank loans and 85 percent of all NPLs.7 Analysts question whether these loans are adequately classified and provisioned against, particularly as loan officers still appear reluctant to downgrade borrowers, either on account of long-established relationships or because of the implications for provisioning and new lending. Moreover, favorable loan classifications sometimes depend on guarantees by other affiliates of parent companies, which could themselves become impaired. Analysts expect that a further slowdown in the economy could lead to a transformation of many gray zone loans into NPLs, necessitating ¥10–15 trillion in additional loan loss charges.

Japan—Methods to Estimate Future Bank Loan Losses

In view of banks’ past loss experience, market analysts generally consider that current provisioning levels are inadequate to cover losses that might arise both from reported nonperforming loans (NPLs) and from loans to troubled borrowers that might become nonperforming in the near future. Analysts base their estimates on how much more provisioning will be needed on different methods, partly depending on the quality of loan data at their disposal:

  • One approach is to compare the ratio of bank loans to GDP at the height of the bubble to its long-term average, which gives a rough measure for the amount of excess loans that needs to be written off. Uncovered loan losses can be calculated by subtracting the cumulative amount of loan losses that has already been recognized.

  • Some analysts have applied assumed loss rates to the amount of outstanding nonperforming and “gray zone” loans. These rates are assumed to increase sharply from historical levels (which can be calculated from bank’s loan books), owing to a weakening economy, a concentration of loans in weak sectors, less room for evergreening, and a tougher approach by bank regulators. Analysts generally refer to the experience with nationalized banks where inspectors discovered a much larger amount of NPLs than had been classified as such by the banks.

  • Another approach, which takes account of the fact that banks continue to experience losses on collateral as long as a loan has not been fully removed from the balance sheet (which may take several years), applies a common loss rate to all loans that have been reported non-performing since the end of the bubble. Estimates for the loss rate can be based on the relatively few loans that have been resolved by loan disposal agencies (such as the CCPC, an institution that resolves credit cooperative loans), or on prices for bad loans on the secondary market.

  • Finally, one approach is to modify loss rates according to the year in which bank loans have been taken out. This also takes account of the fact that losses relate to the decline of collateral values over the lifetime of the loan.

Details regarding the calculations are often proprietary, which makes it difficult to evaluate individual assumptions and estimates on their merit. However, the estimates broadly converge to the conclusion that major and regional banks may hold some ¥20–30 trillion in unrecognized loan losses.

9. Differences in view on the magnitude of the NPL problem largely reflect different assumptions on future loss rates, which in turn depend strongly on the future course of the economy. To illustrate the range of possible outcomes, Table IV.3 shows the amount of uncovered losses for major and regional banks under various scenarios. The table loosely corresponds to a simulation by a major credit rating agency, which has analyzed possible losses across different loan categories under varying macroeconomic conditions.8 Going beyond the estimation problem, however, there are concerns whether adherence to internationally accepted inspection practices is sufficient under Japan’s deflationary environment to reflect the full scale of the bad loan problem. There is likely a need for a more forward-looking approach than typically required by such practices, given the erosion of collateral values and the sharp increase in real debt burden in an environment of price deflation that are unique in recent economic history. Since Japanese banks may not yet have the credit management systems in place to deal with these unusual circumstances, a risk remains that their assessments of the true quality of their loan portfolio are still too optimistic.

Table IV.3.

Japan: Sensitivity Analysis for Uncovered Loan Losses of Major and Regional Banks

(Loan amounts are based on September 2000 loan classification according to banks’ self-assessment; in trillions of yen)

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Sources: Financial Services Agency; staff calculations.

Mechanical loss assumptions are used for the purpose of the simulation.

Collateral refers to both loan collateral and loan guarantees.

Bankrupt borrowers include de facto bankrupt borrowers and borrowers in danger in bankruptcy.

Banks are assumed to hold a combined Y11.7 trillion in general and specific provisions.

Weak Capital and Low Profitability

10. Some market analysts consider that if bad loans were provisioned in accordance with their estimates, a number of weaker banks could become technically insolvent and many others would probably fall below minimum capital requirements. Major banks have achieved the most progress in provisioning for or writing off bad loans, accounting for an estimated 75 percent of around ¥70 trillion in cumulative credit costs for all banks since the end of the bubble. Nevertheless, market analysts estimate that major banks’ aggregate future loan loss exposure equals about half of their Tier-1 capital. Since regional banks remain relatively less well capitalized, notwithstanding some success in raising additional capital in FY2000, analysts estimate that their combined loan loss exposure exceeds their Tier-1 capital. The same conclusion has been reached for credit cooperatives and some of the other small financial institutions, which generally have the lowest capital ratios and are particularly exposed to the small and medium-sized enterprises that are experiencing widespread bankruptcies.

11. Analysts also have concerns about the low quality of major banks’ capital. Following a decade of low profitability and two rounds of public capital injections, more than half of banks’ Tier-1 capital consists of deferred tax assets, public capital, and preferred equity instruments. Accordingly, shareholder equity is relatively small, particularly in contrast to banks’ large exposure to market risk from their equity and JGB portfolios (see below). Moreover, deferred tax assets will expire unless they are claimed against profits over the next five years; banks will eventually want to repay injections of public capital; and preferred instruments will need to be rolled over in the course of the next two years.

Major Banks’ Regulatory Capital (Sept. 2000)

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Source: FSA.

Percent of risk-weighted assets

12. Banks will therefore need to substantially raise profitability over the medium term to deal with the bad loan problem and strengthen their capital base. However, there are as yet few signs that profits will increase substantially in the near future. Major banks’ operating profits in FY2000 were essentially unchanged compared to the year before, as sluggish credit demand continued to erode the average gross lending margin (Figure IV.1). Some banks have recently begun to shift toward fee-based activities such as domestic syndicated lending and investment banking, but these operations are still small and therefore unlikely to generate substantial revenues in the near term, especially in the face of strong competition from established market participants. Banks have also returned to the international loan market in search of higher margins, but this expansion comes at a time when other banks are tightening exposure in anticipation of rising credit risk. Finally, implementation of merger plans is proceeding slowly. Significant synergy gains have yet to be realized, and cost-cutting efforts have so far had only a small impact on operating profits. Partly reflecting market pessimism about bank restructuring, major bank share prices have declined by about 30–40 percent since merger plans were announced in August 1999 (Figure IV.2).

Figure IV.1.
Figure IV.1.

Japan: Major Banks’ Profits, FY1990–2000

(In trillions of yen)

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A004

Source: FitchIBCA.
Figure IV.2.
Figure IV.2.

Japan: Banking Indicators

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A004

Sources: WEFA; and Bloomberg Financial Markets, L.P.1/ Average U.S. dollar LIBOR of Fuji Bank, Bank of Tokyo, and Norinchukln bank minus the LIBOR fix.

High Exposure to Equity and JGB Markets

13. Bank exposure to market risk has increased as falling stock prices eroded banks’ hidden capital gains in 2000. The book value of shares and government bonds held by banks amounts to some ¥38 trillion and ¥44 trillion respectively for the major banks and ¥8 trillion and ¥20 trillion for the regional banks. In March 2000, with the Topix at 1650, major banks reported hidden reserves worth ¥8.1 trillion, but these gains—which had been used in the past to finance bad loan write-offs—evaporated during the year as the Topix slid below 1300.9 The drop in stock prices was short of what would have caused systemic problems, although concerns arose about the degree of losses at some individual banks at around the time that the equity market reached its trough.

14. Banks are also increasingly exposed to a sharp rise in JGB yields. In the absence of attractive lending opportunities, banks have continued to invest surplus funds in JGBs. By mid-2001, the share of government securities in bank assets increased to a record 10 percent, compared to around 4 percent at end-1998. During the year, bond holdings gained in value as 10-year JGB yields fell to low levels, but by the same token, JGB holdings became both less profitable and more risky. A 100 basis point rise in JGB yields is estimated to reduce major banks’ capital by about ¥1 trillion, or 5 percent of Tier-1 capital (based on an assumed average duration of banks’ JGB holdings of about 2 years). The FSA views this exposure as manageable, however and does not consider banks’ interest rate exposure to be a source of significant risk.

B. Policies to Strengthen the Banking System

The Government’s Emergency Package

15. In April 2001, faced with deteriorating confidence in the economy and the financial system, the government announced a package of measures to deal with the related problems of bad loans and corporate debt overhang and to reduce banks’ substantial exposure to equity market risk. Further details of the package emerged in the context of the Council on Economic and Fiscal Policy’s blueprint for economic reform, which was released in June 2001. The package contains two major initiatives:

  • Bad loan disposal. The plan calls for the major banks to eliminate two categories of NPLs—loans to bankrupt and nearly-bankrupt companies, although not loans to borrowers requiring special attention—from their balance sheets over a two-year period.10 While banks can sell NPLs in their entirety or resolve bad loans through the courts, the package emphasizes the principle of fostering corporate reorganization through informal debt workouts along the lines of the London Approach, implying the use of debt forgiveness and debt-equity swaps.11 To this end, a private sector committee recently issued an interim report on voluntary debt workouts, which require a restructured company to return to profitability within three years and clarify the responsibility of both shareholders and company management. Any loans that remain on banks’ balance sheets after the specified period would be sold to the Resolution and Collection Corporation (RCC), which is to play a more active role in bad loan disposal, including through stepped-up securitization and active participation in debt workouts.

  • Reduction in equity risk exposure. To reduce banks’ exposure to market risk, bank stock holdings are to be limited to 100 percent of capital (to be defined as either shareholder equity or Tier-1 capital) from 2004 onwards. A Bank Shareholding Acquisition Corporation (BASAC) is to be established to facilitate scaling down cross-shareholdings.12 The BASAC would purchase stocks over a period of 5 years, with the aim of unwinding its holdings through sales to the public (e.g., in the form of exchange-traded or mutual funds) or repurchases by the issuing companies over the following 5 year period. The government will initially guarantee up to ¥2 trillion of funds for share purchases. Any loss of the BASAC at its dissolution would be covered in the first instance by the contributions of its member banks, which will consist of an aggregate ¥10 billion in initial contributions, plus subordinated contributions equivalent to 8 percent of their sales to the BASAC (effectively a haircut that would be returned if the BASAC returned sufficient profits). The government would cover the remaining loss. Share sales by banks to the BASAC will be voluntary and are to take place at market prices. Relevant legislation is likely to be introduced during the extraordinary Diet session in the autumn of 2001, and the corporation would take up operations early in 2002.

16. Although market analysts generally welcomed the authorities’ willingness to focus on the corporate debt-bad loan nexus, they raised a number of concerns. First, the package only focuses on the major banks, which account for less than half of the banking system’s total assets and problem loans and have stronger asset quality and capitalization than the regional banks. Second, the plan does not address the need for more forward-looking provisioning practices, or call for more aggressive treatment of the large stock of “gray zone” loans whose repayment prospects are also very uncertain. Third, it will be important that corporate restructuring plans submitted in exchange for tax-subsidized debt forgiveness are realistic and provide a sufficient basis for a sustained turnaround in corporate profits.

17. Market participants have also raised concerns about the equity purchase scheme. The scheme has the potential to weaken much-needed market discipline on both banks and corporations, particularly if it comes to be seen as effectively putting a floor under stock prices. At the same time, it allows banks to maintain an equity exposure equivalent to 100 percent of capital—leaving open the possibility that another scheme may be needed in the future. There are also concerns that, by setting a precedent, the plan could lead to other asset-purchasing schemes (for example, to reduce banks’ JGB exposures). Finally, the plan was seen as giving banks too much discretion in choosing the stocks they sell to the scheme, raising the risk that banks could unload the stocks of fundamentally unsound companies on the BASAC—stocks that the BASAC might find impossible to resell later.

Progress in Strengthening the Supervisory and Regulatory Framework

18. Following the first round of on-site inspections of major and regional banks during 1998/99, which focused primarily on asset quality, a second inspection round currently underway concentrates on banks’ risk management systems. It examines the valuation and soundness of financial assets, exposure limits to various types of market risk, and internal monitoring and controls (including in preparation for the introduction of the revised Basel capital adequacy standards). The FSA has released a revised inspection manual for banks, focusing on improved audit functions and including changes made necessary by the transition to mark-to-market accounting. Meanwhile, the first round of inspections of nearly 300 credit cooperatives that began in April 2000 after supervisory authority was transferred from regional governments to the FSA will have been completed by mid-2001. The FSA’s longer-term supervisory priorities include decreasing the time between bank inspections from 2–3 years to one year, and pushing for quarterly instead of semi-annual disclosure of banks’ investment results, with the aim to eventually compile quarterly earnings results.

19. The authorities have reaffirmed their commitment to re-introduce partial deposit insurance in April 2002, although liquid deposits—mainly current deposits—will be fully covered until April 2003.13 Under the new deposit insurance law, which initially was to come into force in FY2001 but was delayed by concerns over the health of the credit cooperative sector, the scope of institutions and types of deposits covered will be widened to include certain bank debentures, interest on deposits, and deposits of public entities. At the same time, to minimize the cost of future bank failures, the new legislation provides for stronger instruments to close troubled institutions and sell the viable parts to an assuming bank. For example, measures have been taken to facilitate the swift transfer of business (ideally over the course of a weekend), including the requirement to maintain adequate information on depositors and loan transactions. In addition, the scope of financial assistance to be provided to the assuming institution has been enlarged, providing (among other things) for the Deposit Insurance Corporation (DIC) to share losses that are incurred from loans transferred from a failed institution.

Changes in the Public Support Framework

20. Public funds have been used in a number of costly bank failures in recent years (Table IV.4). Costs of covering the failure of several financial institutions in the late 1990s amounted to some ¥8½ trillion (1¾ percent of GDP). The disposal of a large number of failed shinkin banks (credit unions) and credit cooperatives conducted in FY2000 cost the government about ¥800 billion. Another ¥17 trillion, which has been used for capital injections and loans to nationalized banks, is expected eventually to be repaid. Taken together, public funds used to address the banking crisis up to this point amount to some 5 percent of GDP, toward the upper end of the range for other industrial countries that have experienced banking crises.14

Table IV.4.

Bank Support Framework

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Source: Deposit Insurance Corporation; and staff estimates.

Staff estimate.

Most of the funds are expected to be recovered, except for ¥8½ trillion in government grants to cover depositor losses.

Established under the Financial Functioning Early Strengthening Law in 1998.

21. In view of the extension of blanket deposit insurance by one more year, cutbacks in the public support framework for the banking sector have also been pushed back until April 2002. Changes in the composition of the framework have raised questions about the government’s ability to facilitate future bank restructuring with public capital. During FY2001, funding for the government’s safety net is to remain unchanged at ¥70 trillion, but the accounts for capital injections and bridge bank financing will be considerably reduced and can only be used to address problems in the credit-cooperative sector before they are phased out in 2002.15 Under the revised deposit insurance law, a new emergency account provides ¥15 trillion to ensure the stability of the financial system in case of a systemic threat (including at the regional level). These funds are available for capital injections, full coverage of deposits, and temporary nationalization in the event of financial instability, although the circumstances under which they could be used have been left vague. The systemic clause, which only the Prime Minister can invoke, appears more restrictive than the Early Strengthening Law that expired in March 2001 (the latter allowed the use of public funds to prevent a credit crunch and promote write-offs of problem loans). This may have weakened an important tool for the government to enable banks to address their bad loan problems more aggressively, and the projected decline in available public funds after FY2002 raises more general concerns about the adequacy of public support for bank restructuring in the absence of a systemic crisis.

C. Restructuring in the Banking and Insurance Sector

Failures, Mergers and Strategic Alliances

22. Most of the banks that failed and were nationalized since 1998 have been reprivatized. In March 2000, LTCB was sold to a private consortium led by foreign investors, and in September 2000, ownership of NCB was transferred to a domestic consortium. Both banks were cleared of most of their bad assets, received public capital injections, and submitted ambitious restructuring plans to the government, including commitments to maintain strong capital adequacy ratios. In August 2000, the first of five regional banks that failed in 1999 was transferred to a new owner. Purchasing agreements have been completed for the remaining four, including with two foreign investors, and the process of reprivatizing them is expected to be essentially complete by mid-FY2001.

23. The reorganization of Japan’s banking system advanced in April 2001, when the remaining three of the four major banking conglomerates took up combined operations. Following the example of Mizuho—a bank holding company that united three of the largest banks under one roof in October 2000—two organizations (UFJ and Mitsubishi Tokyo) have also opted for a holding structure, while Sumitomo and Sakura Bank underwent a full-scale merger.16 Restructuring plans for the new institutions have generally been strengthened, including through the announcements of further personnel cuts over the medium term, but the full integration of computer systems is not expected to be achieved before 2003 in most cases. The completion of the Big Bang reforms prompted greater cooperation between banks and trust banks, some of which have joined one of the major alliances, and between banks and insurance companies (see below). The lack of a strong retail network has also led major banks to cooperate more closely with regional banks, and some banks have begun to work with the postal savings system to improve access to banking services through ATMs in post offices and other avenues.

24. Restructuring among regional banks also picked up during FY2000, mainly in the context of a number of mergers and cooperation agreements, and core profitability has been boosted by expenditure reductions and an improvement in the net interest spread. Moreover, banks have generally managed to strengthen their customer bases. Many banks replenished capital, decreasing the number of banks with capital adequacy ratios below 8 percent from 31 to 25 in the six months to September 2000.17 Six more banks applied for public capital injections before the deadline expired at end of FY2000. On the credit cooperative side, the number of institutions declined from 373 to 291 in the five years ending March 2000. A total of 53 credit cooperatives failed, one was liquidated, and 28 were absorbed by mergers. The process of consolidation picked up steam as the FSA completed its first round of inspections in FY2000 (credit cooperatives had previously been supervised by local governments). The FSA closed a total of 12 institutions during the fiscal year and more failures are widely expected.

New Entrants to the Banking Sector

25. Competition in the banking system is intensifying as domestic nonfinancial competitors make inroads, armed with new business models such as banking through retail outlets or internet banking. The demand for such services has required changes to the regulatory framework, particularly in view of concerns that the new banks might be excessively vulnerable if their nonbank parent companies experience financial difficulties. To address these concerns, in March 2001 the FSA submitted legislation that would require FSA approval for nonbanks to hold more than a 5 percent stake in a bank. Shareholders with a stake exceeding 20 percent, or otherwise having strong influence on the bank, could be subject to financial inspections if questions regarding the sound management of the bank emerged. A majority shareholder could be asked to shoulder the losses of its banking subsidiary if the subsidiary experienced financial difficulties. Moreover, regulations will be in place to ensure the operational independence of banks from major stakeholders, to subject the sharing of customer information between banks and parent companies to operational safeguards, and to prohibit banks from bailing out parent firms and other affiliates.

26. The new legislation is to replace existing FSA guidelines by the end of FY2001 at the latest. The opening of the sector to new entrants paved the way for the re-privatized NCB to start business (one principal shareholder is a nonfinancial company) and has led to applications for several new banking licenses, most of which have already been granted. By mid-2001, four new banks have started operations that use the Internet as a main channel for the delivery of financial services or use convenience-store ATMs to deliver services to customers.

The Life Insurance Sector

27. Policy cancellations and sluggish sales at life insurance companies continued to depress premium income during FY2000, magnifying the longstanding problem of negative yield spreads.18 Insurers were also affected by declining stock prices, which reduced latent profits on their sizable equity holdings, and by deteriorating loan quality. As a result, solvency margin ratios for the major 7 life insurers, while still on average about triple the mandated 200 percent minimum, have declined by about 180 percentage points during FY2000.19

28. Combined with an adverse economic environment, these difficulties contributed to several failures among mid-size life insurers over the past year, bringing to seven the number of institutions that have failed since 1997. Three companies filed for bankruptcy under the modified Law on Special Reorganization Procedures for Financial Institutions passed in mid-2000 that provides for quick restructuring under court protection, including through a possible cut in guaranteed yields. All of the failed companies have in the meantime concluded purchasing agreements with sponsoring institutions and have resumed operations under their new parents. The resolution of some cases required assistance from the Life Insurance Policyholders Protection Corporation, whose initial ¥960 billion in funds have now declined to ¥420 billion—an amount approximately equivalent to previous government injections.

29. The government has taken a number of measures to improve supervision of life insurers. Life insurers have undergone one round of FSA inspections, focusing partly on loan quality, and an inspection manual for the insurance sector was finalized in the summer of 2000. From April 2001, the formula to calculate the solvency margin has been changed to include the risks from investment in unlisted shares, domestic bonds and foreign securities, evaluated at market prices. Although the change is expected to lower margins by about 50-200 percentage points, the remaining insurers would remain well above the 200 percent mark that would trigger FSA intervention. The FSA has also required insurance companies to publish more financial information, including core profits from insurance business, twice a year (disclosure of interim results is currently voluntary). Moreover, in a recently released interim report, the Financial System Council (FSC) suggested steps to make it easier for companies to build capital, including through a revision of the requirement to pay out at least 80 percent of annual profits as dividends to policyholders. The FSC also proposed to allow insurance companies to reduce guaranteed returns on insurance policies outside a formal restructuring process (a right that was suspended in 1996), provided policyholders participated in the decision-making process.

30. Foreign insurers have used recent failures of life insurance companies as an opportunity to gain a stronger foothold in the Japanese market. Five of the seven companies that failed have been taken over by major foreign companies, and three smaller insurance companies have also come under foreign control. Domestic insurance companies have responded to increased competition by forging a web of alliances and mergers in an attempt to solidify their financial bases before a wider opening of the insurance market to banks and foreign companies occurs.20 Domestic companies will also have an opportunity to branch into “third sector” products that include relatively new products such as medical care and cancer insurance and that so far have been largely reserved to foreign competitors. Mergers have mostly been concentrated in nonlife insurance (which will be particularly affected by the opening of the third sector), but life insurers have also begun to build alliances with nonlife companies. The benefits of cross-sectoral cooperation are mutual, combining the stronger financial positions of nonlife companies with broader sales networks of life insurers.

D. Remaining Challenges

31. Looking ahead, a key challenge for the authorities is to restore the financial health of the banking system, in particular through a speedy resolution of the bad loan problem. An important task will be the continued strengthening of loan classification and provisioning practices, which could result in the downgrading of gray zone loans. Moreover, the new initiative to accelerate bad loan disposal should be pursued rigorously, with efforts to include regional banks and credit cooperatives in the process. In view of the possibly sizable losses that could result from higher write-offs, further targeted public capital injections may be needed to recapitalize banks with viable business franchises to prevent a credit crunch and maintain systemic confidence. To limit moral hazard, such injections would need to carry appropriate conditionality, including performance criteria that ensure banks’ active participation in debt workout agreements, and a credible threat to convert preferred into ordinary shares in case of noncompliance.21

32. Now that a legal and institutional framework for corporate debt restructuring is largely in place, the authorities need to provide incentives that force both creditors and borrowers to use the tools that have been provided. While regulatory pressure and performance targets for recapitalized banks could provide a push for debt workouts from the lending side, substantive deregulation of the weaker sectors of the economy would expose bank borrowers to stronger market forces and bolster incentives for workouts from the borrowing side. Once implemented, recent proposals by the Council on Economic and Fiscal Policy and in the draft guidelines for debt workouts could add further support to a market-driven resolution of the bad loan problem, for example by requiring that independent experts assess whether informal workout arrangements are adequate to restore financial viability. In addition, planned measures to liquefy the secondary market for bad loans, including by liberalizing the real estate market and providing for a more active role of the RCC could be crucial in helping banks to dispose of bad assets (for example, through securitization).

33. Finally, the opening of the financial sector to new entrants, both in the banking and insurance industries, should lead to greater competition and a general improvement in the provision of financial services. The government would have two crucial roles to play. First, financial intermediation would benefit from a gradual reduction in the role of government financial institutions, including the postal savings system, which is indeed now under active consideration under the new government’s 7-point plan. Second, the government would need to have a strategy in place that would ensure the timely exit of unviable institutions from the market.


Prepared by Martin Mühleisen (x38686).


The financial year begins April 1.


The FRL definition of NPLs includes claims on borrowers in or near bankruptcy and claims on borrowers requiring special attention (mainly those with restructured loans and loans past due by more than three months).


Superior collateral includes deposits and other financial instruments (e.g., government bonds) of high quality that are easily disposable. Ordinary collateral includes other types of disposable collateral (e.g., real estate).


Loans to classified borrowers by all deposit-taking institutions included ¥48 trillion in NPLs as of September 2000 (see Table IV.2).


Loans that are fully provisioned up to the value of collateral and guarantees can be carried on the balance sheet with zero value (“partial write-off”). The loans remain on the books until all claims relating to the loan have been resolved (“final disposal”), which can take years unless the loan is sold or forgiven.


Loans to just three sectors (real estate, construction and retail) account for about a quarter of all loans and almost half of bad loans.


FitchIBCA (May 2001), Japanese Banks: Loan Loss Simulation for Japanese Banks Based on Newly Disclosed Problem Loan Data. According to Fitch, the macroeconomic scenario underlying the worst case scenario in Table IV.3 corresponds to a sharp recession, followed by meaningful structural change and a gradual economic recovery.


Some private sector analysts estimate that banks accumulate losses on their equity portfolio once the Topix slides below 1,270 points, with every 100 point change translating into a capital gain or loss of about ¥2½ trillion. The FSA considers the effect of changes in the Topix to be about two thirds of that amount.


New NPLs would have to be written off within three years from the date they are classified as nonperforming. According to the FSA, while the plan focuses on the major banks, their efforts to remove bad loans from their balance sheets will inevitably require regional banks to do the same.


The London Approach brings major creditors and other parties together on an informal basis to reach a collective decision on the feasibility of a corporate debt workout and on how to share the related losses. The role of the authorities would largely be that of resolving coordination problems as an honest broker.


Banks hold shares worth an estimated 130–150 percent of bank capital. A target exposure of 100 percent of capital implies that banks would have to sell ¥10–15 trillion in shares.


The new deposit insurance framework would cover ¥10 million per depositor plus interest.


By comparison, the public costs of the U.S. savings and loan crisis amounted to 2.5 percent of GDP.


The current spending limit of ¥6 trillion in the DIC’s General Account—which is partly funded through insurance premia—will be maintained after March 2002.


Sanwa Bank and Tokai Bank are slated to merge in early 2002, and Mizuho plans to reorganize its operations into two subsidiaries, dealing separately with corporate and retail customers.


Banks that are not internationally active face a 4 percent minimum capital requirement.


The yield spread is the gap between guaranteed rates of return on policies and returns on assets.


The solvency margin measures an insurance company’s ability to maintain payments to policyholders against exposure to different categories of risk.


The consolidation of insurance companies has so far occurred largely along the lines of the four major banking groups, likely heralding a shift toward greater integration of banking and insurance services following the completion of the Big Bang reforms.


The FSA has emphasized its view that, in order to limit moral hazard, decisions to inject public funds should be based on true need and limited to systemically important cases.