Abstract
This Selected Issues paper analyzes the key features of the Japanese business cycle, and investigates whether the current recovery differs from past recoveries. In particular, this paper poses the following questions: what are the main characteristics of Japanese business cycles since 1980, and what happens to output, expenditure components, and prices over the cycle? The paper reviews the recent performance and policy issues with respect to the banking sector, insurance sector, and public financial sector in Japan. The stability of the financial sector is also assessed.
II. Recent Financial Sector Developments and Policies1
A. Introduction
1. This paper reviews recent financial system developments and policies. The starting point is the Financial System Stability Assessment (FSSA) report of August 2003, which provided a broad assessment of the financial sector. The FSSA concluded that the bank-dominated Japanese financial sector remained fragile notwithstanding a series of policy measures and that financial sector weaknesses had held back prospects for a sustained recovery. The recommendations of the FSSA and their current status are summarized in Box II.1.
2. Recent financial sector developments indicate that the economic recovery and steady regulatory pressure have improved the health of the financial system. Stronger economic growth and an increase in equity prices have improved the quality of bank assets and capital, and steady regulatory pressure has facilitated deleveraging and restructuring. Financial stability is improving in line with the economic recovery and the government safety net has proven to be effective, although some signs of vulnerability remain.
3. The structure of paper is as follows. Section B describes the recent performance and policy issues with respect to the banking sector, insurance sector, and public financial sector. Section C assesses the stability of the financial sector and Section D summarizes the broad policy implications.
B. Recent Performance and Policy Issues
Banks
Recent performance
4. The banking system is becoming healthier in the context of the recovery and financial policies. Balance sheet stresses are easing as the quality of assets and capital improves. However, there is increasing divergence among banks and aggregate operating profits of the sector have not picked up.
5. Bank net income improved during FY2003 (ended March 2004). For the first time in three years five of the seven large bank groups posted positive net income, mainly due to a large turnaround in the value of equity holdings as well as lower credit costs (losses stemming from loan provisioning, write-offs and sales) brought on by the recovery and ongoing restructuring efforts of the banks.2 Net income of the 89 listed regional banks (which account for about 40 percent of bank credit) also improved with only five reporting net losses in FY2003 compared with 24 the previous year.
FSSA Key Policy Recommendations
The FSSA recommended a number of policy measures to strengthen the banking system and improve financial supervision. During the past year, steps consistent with these recommendations have been taken:
• Improve recognition of and provisioning for problem loans
Recommendation: make more extensive use of forward-looking expected loss estimates, rather than relying on historical loss experience for provisioning; allow provisions required by the supervisors to be recognized as a cost for tax purposes, thus making it easier for banks to provision against bad loans;
Steps thus far: the FSA made changes to its inspection manual, encouraging large banks to use the forward-looking discounted cash flow (DCF) method in provisioning on loans to large borrowers (greater than ¥10 billion) classified as “need special attention” or below. In addition, either the DCF or the expected loss amount method can be used for large bank provisioning against classified loans for other borrowers. The tax treatment of losses has been eased somewhat with the extension of the loss carry forward period from 5 to 7 years.
• Strengthen bank capital
Recommendation: to improve the quality of bank capital, limit the use of deferred tax assets (DTAs) in regulatory capital; and to hold all banks to a rigorous capital standard, raise the capital requirement for all domestic banks to at least 8 percent (it is 4 percent for banks that are not internationally active);
Steps thus far: the FSA asked major banks to enhance the disclosure of information about DTAs and continues to encourage external auditors to strictly assess DTAs. Also, the Japan Institute of Certified Public Accountants (JICPA) requested audit firms to conduct stricter audits with respect to the confirmation of DTAs.
• Recapitalize banks subject to strict conditionality
Recommendation: adopt a broad restructuring strategy under which systemically important, undercapitalized banks that are unable to raise sufficient capital in the market would be taken over, recapitalized, brought under new management, and reprivatized;
Steps thus far: the Diet passed a law in June aimed at regional financial institutions providing for preemptive recapitalization on a voluntary basis.
• Bolster bank governance
Recommendation: require banks to adopt corporate governance reforms consistent with Basel Committee guidelines, including outside directors and a board audit committee;
Steps thus far: following government intervention one banking group has changed its governance structure to the audit committee system option provided by the April 2003 revisions of the Commercial Code.
• Strengthen supervision
Recommendation: in order to improve the FSA’s effectiveness, give the FSA full operational autonomy, confine its responsibilities to supervision, provide it with additional resources, and continue to enhance its human capital;
Steps thus far: the FSA has enhanced the expertise of its staff by developing specialists in banking, securities, and insurance and is hiring private sector experts such as CPAs, lawyers, actuaries and reinsurance specialists.
• Government involvement in the financial sector
Recommendation: limit the preferential treatment accorded to public financial institutions and restrict the activities of Japan Post, Kampo and the government lending agencies;
Steps thus far: in April 2004 the Council on Economic and Fiscal Policy issued a paper listing issues to be discussed for the privatization of Japan Post. In addition, the lending of government financial institutions is expected to be reduced by half (as a ratio to GDP) in the future.
Net Income and Operating Profits, Seven Major Banking Groups, Fiscal Years 2002 and 2003
(Yen trillions)
Net Income and Operating Profits, Seven Major Banking Groups, Fiscal Years 2002 and 2003
(Yen trillions)
| FY2002 | FY2003 | |
|---|---|---|
| Net operating profit | 4.56 | 4.44 |
| - Loan loss charges | 5.43 | 4.04 |
| + Equities, net | -3.14 | 0.63 |
| + Other | -0.49 | -0.22 |
| - Taxes, minority interests | 0.12 | 1.45 |
| = Net income | -4.62 | -0.64 |
| Memorandum item: | ||
| Net income (excl Resona) | -3.78 | 1.03 |
| Net income (excl Resona and UFJ) | -3.17 | 1.43 |
Net Income and Operating Profits, Seven Major Banking Groups, Fiscal Years 2002 and 2003
(Yen trillions)
| FY2002 | FY2003 | |
|---|---|---|
| Net operating profit | 4.56 | 4.44 |
| - Loan loss charges | 5.43 | 4.04 |
| + Equities, net | -3.14 | 0.63 |
| + Other | -0.49 | -0.22 |
| - Taxes, minority interests | 0.12 | 1.45 |
| = Net income | -4.62 | -0.64 |
| Memorandum item: | ||
| Net income (excl Resona) | -3.78 | 1.03 |
| Net income (excl Resona and UFJ) | -3.17 | 1.43 |
6. Higher equity values, in turn, led to improvements in the adequacy and quality of bank capital in FY2003. Furthermore, the ratio of deferred tax assets (assets recognized as possible tax refunds based on future positive earnings projections and counted as regulatory capital) to tier 1 capital of the major banks (excluding the Resona Bank) was reduced from 58 percent in March 2003 to 39 percent in March 2004. Capital adequacy for the 89 listed regional banks improved in FY2003, although 17 regional banks still had capital-to-asset ratios of below 8 percent.
7. The major banks are on course to meet the government’s target of halving the aggregate nonperforming loan (NPL) ratio to about 4 percent by April 2005. The recent reduction in NPLs is accounted for by sales of written down loans, foreclosure and other court action, and corporate restructuring, as evidenced by declining corporate leverage. The reduction reflects several years of steady regulatory pressure. Regional banks reduced their average NPL ratio during FY2003 although it remains above that of the major banks.
Ratio of NPLs to Total Loans
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Financial Services Agency.Ratio of NPLs to Total Loans
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Financial Services Agency.Ratio of NPLs to Total Loans
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Financial Services Agency.8. Notwithstanding these favorable trends there are several areas of remaining concern. First, operating profits have not improved. While banks managed to reduce operating costs in FY2003, net interest income also declined as overall bank lending continued its trend decline. Also, the loan-deposit interest rate spread remained broadly unchanged year over year. On a more positive note fee income of the large banks increased, suggesting that banks are beginning to tap new and less risky revenue sources.
9. In addition, two large banks experienced difficulties. Resona bank was found to be undercapitalized last year and is undertaking substantial restructuring. UFJ, based on the inspection results by the FSA and discussions with auditors, significantly increased provisions and marked down earnings. Reflecting the troubled status of these two banks the level and quality of capital varies sharply across the seven major banks.
Capital Adequacy, Seven Major Banking Groups, Fiscal Year 2003
(Ratios to risk weighted assets)
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Fitch Ratings and FSA.Capital Adequacy, Seven Major Banking Groups, Fiscal Year 2003
(Ratios to risk weighted assets)
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Fitch Ratings and FSA.Capital Adequacy, Seven Major Banking Groups, Fiscal Year 2003
(Ratios to risk weighted assets)
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Fitch Ratings and FSA.10. Finally, the lack of improvement in bank operating profits argues for a further strengthening in bank governance. Historically bank boards included few or no outside directors. The insular governance structure goes hand in hand with the slow pace of adoption of sophisticated risk management systems (the FSA is working with the banks to improve these systems as described in the next section) and new product development. Revisions to the Commercial Code in April 2003 gave companies a new governance structure option that includes board of director committees with majority outside directors and outside auditors. However, this new option has been adopted only by Resona bank following government intervention. In addition, four banks have taken on a small number of outside directors.
Policy issues
11. The government has continued to implement new policies in support of financial sector restructuring. These were reflected in the Program for Financial Revival (PFR)—announced in October 2002—which is intended to reduce major banks’ NPL ratio to about half by FY2004 and create a stronger financial system to support structural reform and higher economic growth. The main elements are as follows:
Use of the discounted cash flow (DCF) method for large bank provisioning—The FSA made changes to its inspection manual encouraging large banks to use the DCF method in provisioning on loans to large borrowers (greater than ¥10 billion). In addition, either the DCF or the expected loss amount (based on default rates or the probability of bankruptcy) method can be used for large bank provisioning against classified loans for other borrowers. Other banks can use DCF on a voluntary basis, although there is limited information on the extent to which they have done so;
Recognition of provisions as a cost for tax purposes—The tax authorities only recognize provisions against the worst categories of loans as an allowable expense for the calculation of taxable income. In response to an FSA proposal, the tax authorities have extended the carry over period for provisioning from 5 to 7 years applied to deficits incurred beginning on FY2001. In addition, the FSA considers that further tax reform is needed and may request tax reform measures to facilitate the reduction of DTAs by the end of August 2004;
Reduction in DTAs—In addition to proposals regarding the taxation of loan provisions in October 2003, the FSA requested major banks to enhance the disclosure of information on future taxable income, which forms the basis for DTAs;
Special inspections of large borrowers of large banks—The FSA conducts several types of special inspections to foster bank restructuring. The results of the most recent round of special inspections announced in April indicated that the amount large banks needed to set aside for the nonperforming loans of inspected borrowers decreased by one-third during FY2003. In addition, the number of borrower downgrades and upgrades was about the same, whereas in the previous inspections downgrades had been greater. Also, the FSA has begun a new type of inspection focused on banks’ credit risk management for large borrowers;
Results of Special FSA Inspections
Results of Special FSA Inspections
| March 2003 | September 2003 | March 2004 | |||||
|---|---|---|---|---|---|---|---|
| Number of debtors | Credit (Yen trillions) | Number of debtors | Credit (Yen trillions) | Number of debtors | Credit (Yen trillions) | ||
| Total | 167 | 14.4 | 161 | 13.1 | 133 | 10.5 | |
| Upgraded | 17 | 1.9 | 6 | 0.3 | 23 | 1.3 | |
| Unchanged | 119 | 9.9 | 131 | 10.9 | 82 | 6.9 | |
| Downgraded | 27 | 2.4 | 24 | 1.9 | 26 | 2.2 | |
| Removed from balance sheet | 4 | 0.2 | -- | -- | 2 | 0.1 | |
| NPL disposal losses | 1.3 | 0.9 | 0.4 | ||||
| Write-offs | 0.8 | 0.3 | 0.4 | ||||
| Higher provisions | 0.5 | 0.6 | 0.0 | ||||
Results of Special FSA Inspections
| March 2003 | September 2003 | March 2004 | |||||
|---|---|---|---|---|---|---|---|
| Number of debtors | Credit (Yen trillions) | Number of debtors | Credit (Yen trillions) | Number of debtors | Credit (Yen trillions) | ||
| Total | 167 | 14.4 | 161 | 13.1 | 133 | 10.5 | |
| Upgraded | 17 | 1.9 | 6 | 0.3 | 23 | 1.3 | |
| Unchanged | 119 | 9.9 | 131 | 10.9 | 82 | 6.9 | |
| Downgraded | 27 | 2.4 | 24 | 1.9 | 26 | 2.2 | |
| Removed from balance sheet | 4 | 0.2 | -- | -- | 2 | 0.1 | |
| NPL disposal losses | 1.3 | 0.9 | 0.4 | ||||
| Write-offs | 0.8 | 0.3 | 0.4 | ||||
| Higher provisions | 0.5 | 0.6 | 0.0 | ||||
Disclosure of the gap between major banks’ self-assessments and the results of FSA’s regular inspections—Three rounds of inspections concluded that the gaps between the assessments of the banks and those of the FSA have narrowed considerably.
12. The authorities are also devoting more attention to the regional financial institutions:
Plan to improve the operation of regional financial institutions—In March 2003 the FSA formulated an “Action Program concerning Enhancement of Relationship Banking Functions” to “solve the NPL problem by enhancing functions of relationship banking and taking steps to revitalize SMEs and activate regional economies.” As of October 2003 some 626 financial institutions had submitted detailed plans;
New framework for public fund injection—This is aimed at regional financial institutions with a view to encouraging management reform, and revitalizing local economies. Institutions would submit applications to the Deposit Insurance Corporation including a plan with numerical profit targets and measures to revitalize the local economy. The plan would be assessed against a publicly reported list of standards. Bank capital would be essentially in the form of preferred stock while capital for cooperatives would be preferred stocks or subordinated loans. The framework is supported by ¥ 2 trillion in the government budget and is available until March 2008.
13. Finally, several steps have been taken ahead of the further partial withdrawal of deposit insurance in April 2005. At that time, protection will be limited to the first ¥10 million of the interest and principal of interest-paying demand deposits.3 Financial institutions are expected to offer fully-protected zero-interest deposit accounts for settlement purposes (withdrawal is allowed any time on demand) with a view to minimizing possible disruptions.
Insurance sector
14. The financial conditions of the six major life insurance companies improved in FY2003 as the sharp rise in stock prices more than offset a smaller fall in bond prices. The rise in equity prices helped boost the solvency margin at six insurers to 791 percent, compared to 555 percent a year earlier.4 Also, operating performance was improved by cost cutting and better fund management. However, all of the major six life insurers continued to report that the decrease in the amount of policies due to surrender, lapse and termination of policies exceeded the amount of new policies they sold. Moreover, investment returns continue to lag behind the guaranteed yields the insurers promised to pay holders of policies in the past resulting in a “negative spread”.
15. The performance of the nonlife insurance companies is also improving. Higher equity prices reduced capital losses and valuation losses on stockholdings of the ten major nonlife insurers all of whom posted a net profit for FY2003 compared to four insurers that incurred a net loss in FY2002. The solvency margin ratio also improved for all ten, although premium revenue declined for seven of the large insurers.
16. The major policy change for the life insurance industry is an amendment to the Insurance Business Law aimed at providing an incentive for insurers to shore up their balance sheets. The amendment allows companies, under restrictive conditions, to reduce the guaranteed yields for existing policies with the support of representative shareholders. Lower guaranteed yields would reduce losses and lead to healthier balance sheets. That said, market analysts suggest that companies may well not reduce their guaranteed yields since this would be tantamount to admitting that the company is not viable in the longer run.
Public financial sector
17. The public financial sector, consisting of Japan Post and the nine government financial institutions (GFIs), plays a key role in Japan’s financial system. Japan Post—the largest deposit-taker in the world—offers payment services and life insurance products and is exempted from the deposit insurance premium and corporate taxes. The nine GFIs are state-owned and specialize in lending (with one exception). The Government Housing Loan Corporation (GHLC) has 30 percent of total mortgage loans and the public sector accounts for about 20 percent of all loans to SMEs.
18. Japan Post is contracting but still accounts for a large share of total deposits and life insurance. Deposits amounted to ¥227 trillion at end-March 2004 (about one-quarter of total financial system deposits), down from the peak of ¥260 trillion in March 2000. Funds deposited with Japan Post’s insurance company, Kampo, amounted to ¥119 trillion at end-March 2004.
19. In April 2004 the Council on Economic and Fiscal Policy issued a paper listing issues to be discussed with regard to the privatization of Japan Post. The key issues include the maintenance of the post office network, and the need for due consideration of employment levels (staff now totals about 280,000). Privatization is expected to start in 2007 and be completed 5–10 years from then. The long transition is seen as appropriate by the government and similar to the experience of other countries. The government guarantee would likely remain in force for deposits and insurance policies in place prior to privatization, while post-privatization deposits and policies would be covered under the same system as applies to the private sector. For instance, Japan Post would be expected to make premium payments to the Deposit Insurance Corporation and pay tax on any profits. A final report with specific recommendations is expected to be issued by the Council around the fall of this year.
20. GFI reforms are also underway. The ministries overseeing GFIs delegated the inspection of their risk management to the FSA from April 2003 to help bring GFI practices more in line with those of private financial institutions. This and other reforms are aimed at imposing greater market discipline and improving information disclosure.5 The GHLC is shifting its main focus to securitizing housing loans originated by private lenders and will be reorganized by FY2006 into an independent administrative agency.
C. Updated Assessment of the Financial Sector
21. The systemic stability of the financial system has improved during the past year. Large exposures to major problem borrowers are slowly being reduced as growth picks up. There are as yet no signs of banking strains ahead of the April 2005 cutback in deposit insurance coverage. Cross-shareholdings between banks and insurers have declined significantly, thus reducing the potential systemic implications of the insurance industry (although insurance companies remain the major investor in bank preference shares and banks are the major investors in insurance company capital instruments). Further, Japan’s strong external position means that the banking system is not vulnerable to external shocks. Systemic risk continues to be mitigated by an effective government safety net and the government’s willingness to recapitalize troubled banks.
22. Banks’ aggregate market risk exposures are also likely to have improved. An increase in interest rates would impose larger capital losses on the major banks owing to their increase in JGB holdings from 10 percent of assets in FY2003 to 15 percent in FY2004 (the FSA says that banks actively hedge interest rate risk). At the same time, higher rates would likely be accompanied by higher growth and a resumption of inflation which should widen credit spreads, lower credit costs, and lift stock prices and loan growth. Although bank equity portfolios have shrunk in relation to capital they remain large and thus banks remain vulnerable to a fall in equity prices.
23. Notwithstanding these improvements, signs of vulnerability remain:
Many individual banks are still weak. The intervention of two large banks during 2003 and the higher loan write-downs by UFJ in the spring of 2004 suggest that adjustment may not be complete for the industry as a whole;
A number of regional banks, which in many regions are dominant lenders, have significant weaknesses which have not yet been resolved;
Although capital ratios appear satisfactory, weak core earnings means any loss has an impact on capital rather than simply on that year’s net income;
A large share of capital, especially for the major banks, still consists of DTAs and government-owned preference shares;
The inherent financial strength of banks as indicated by ratings remains quite low. In recent months most of the major banks have been upgraded by the major rating agencies. However, the gap between their individual ratings (which abstract from government support) and bank long-term debt ratings remains quite wide, and the individual ratings of Japanese banks remain much lower than those of large international banks which are in the AA- to AA+ range.
Average Japanese Major Bank Ratings: Long-Term and Individual
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Fitch Ratings.Average Japanese Major Bank Ratings: Long-Term and Individual
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Fitch Ratings.Average Japanese Major Bank Ratings: Long-Term and Individual
Citation: IMF Staff Country Reports 2004, 247; 10.5089/9781451820577.002.A002
Source: Fitch Ratings.D. Broad Policy Implications
24. A strengthening of financial policies could further enhance the stability of the financial system. Recent financial developments indicate that the stability of the financial sector has improved with the economic recovery and with steady regulatory pressure. Stability could be further improved by policies aimed at boosting the quality of bank capital, improving bank governance, reducing competition from the public financial sector, and rationalizing the regional banks.
25. Looking ahead, the focus of financial policy may gradually shift from entrenching stability to ensuring that the financial sector fully contributes to economic growth. The long period of adjustment of the financial sector following the bursting of the bubble in the early 1990s has helped hold back economic growth. The contribution of the financial sector to growth could be enhanced by intensifying competition in the financial sector with a view to improving the performance of the banks and developing nonbank sources of private sector financing.
Prepared by Mark Stone (ext. 36532) and Peter Hayward.
These comprise seven major banking groups: Mizuho Financial Group (Mizuho Bank, Mizuho Corporate Bank, Mizuho Trust Bank); Mitsubishi Tokyo Financial-Group (The Bank of Tokyo-Mitsubishi, Mitsubishi Trust and Banking); UFJ Holdings (UFJ Bank, UFJ Trust Bank); Sumitomo Mitsui Financial Group (Sumitomo Mitsui Banking Corporation); Resona Bank; Mitsui Trust Holding (The Chuo Mitsui Trust and Banking); and, Sumitomo Trust.
Withdrawal of the full guarantee for time deposits was completed in April 2002.
Insurance companies in Japan must satisfy a minimum solvency margin which is the ratio of available capital and surplus to a measure of insurance risk, assumed interest rate risk, asset management risk and operational risk.
Japan Post was used to finance the GFIs, special public corporations, and local governments via the Fiscal Investment and Loan Program (FILP). The compulsory transfer of funds from Japan Post to FILP was abolished in April 2001.
