JAPAN

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JAPANS BANKING SYSTEMFROM THE BUBBLE AND
CRISIS TO RECONSTRUCTION

• Masahiro Kawai
• Institute of Social Science
• University of Tokyo
• Japan
• Center for Global Partnership Conference
• Macro/Financial Issues and International
  Economic Relations
• Policy Options for Japan and the United States
• Tokyo, May 13, 2004

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PRESENTATION

• I. INTRODUCTION
• II. MACROECONOMIC DEVELOPMENTS AND THE BANKING
  SECTOR
• CAUSES OF THE BANKING SECTOR CRISIS AND
  DIFFICULTIES
• IMPACT OF BANKING SECTOR DISTRESS
• POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND ITS
  PROGRESS
• CONCLUDING REMARKS

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I. INTRODUCTION

• What are the factors behind the recent banking
  sector difficulty, particularly the 1997-98
  systemic crisis, in Japan?
• Why did the government fail to address the
  problem early, quickly and decisively?
• Since the crisis, has the FSA formulated and
  implemented a comprehensive policy to resolve
  banking sector problems?
• Has there been sufficient progress on financial
  sector and corporate sector restructuring?
• Is the worst over in the Japanese banking system?
  Is the banking sector solvent? What are risks?
• What should be done to transform the Japanese
  banking system into a competitive market-based
  system?

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II. MACROECONOMIC DEVELOPMENTS AND THE BANKIG
SECTOR

• 1. Macroeconomic Performance and Policy
• Output stagnation (Figure 1) The average annual
  growth rate of real GDP was 1.1 percent during
  the last decade, 1992-2002. Near-zero growth
  (0.1) in 1998-2002. In addition, nominal GDP has
  been more stagnant (-1.2 in 1998-02).
• Price deflation (Figure 2) The average annual
  inflation rates during 1992-2002 were low or
  negative at 0.2 for CPI and -0.1 for GDP price
  deflators. The GDP deflator fell in 1995-2002
  (except 1997) at 1.0 per year and CPI fell in
  1999-2002 at 0.7 per year.
• High unemployment rate, reaching a peak of 5.5.
• Keynesian fiscal spending in 1992-2002, rising
  from the average size of 32 of GDP in 1991 to
  39 in the early 2000s, with a declining fiscal
  revenue (from 34 of GDP in 1991 to 31
  recently).

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II. MACROECONOMIC DEVELOPMENTS AND THE BANKIG
SECTOR (contd)

• 2. Asset Prices
• There was an asset price bubble in the late
  1980s. The increases in asset prices were much
  faster than nominal GDP (Figure 3).
• The equity price reached its peak in December
  1989 and has since then declined as a trend.
• The urban land price for six major city areas
  reached its peak in September 1991 and since then
  has been declining persistently.
• Relative to nominal GDP (1980100), the land
  price became lower in 1996 and the equity price
  in 2002.

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II. MACROECONOMIC DEVELOPMENTS AND THE BANKIG
SECTOR (contd)

• 3. Banking Sector Conditions
• Expansion of bank loans in the late 1980s,
  together with the expansion of bank deposits
  (Figure 4). Loans were extended to firms with
  assets such as land as a collateral.
• Loans were concentrated in wholesale and retail
  trade, real estate, finance and insurance, and
  construction (Table 1).
• The bursting of the bubble in the early 1990s
  made highly indebted firms in these sectors
  unable to repay due to the decline in collateral
  values, thus creating non-performing loans
  (NPLs).
• But bank exposure to certain sectors, such as
  real estate and construction, continued to expand
  until the second half or the middle of the 1990s.
• As a result, NPLs rapidly increased in the
  banking sector, and the banking system fell into
  a systemic crisis in 1997-98.

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III. CAUSES OF THE BANKING CRISIS

• 1. Overextension of Loans during the Bubble
  Period
• Several factors led to loan overextension in the
  second half of the 1980s.
• Financial liberalization and greater
  opportunities for risk-taking Financial
  liberalization in the mid-1980s allowed small
  financial institutions to venture into new areas,
  particularly funding housing finance companies
  (Jusen) and other real estate investments.
• Shifts in bank clients to non-manufacturing
  firms With large firms increasingly having
  access to capital markets, major banks began to
  direct their loans towards non-manufacturing
  firms, like in real estate, construction and
  SMEs,
• Unwarranted expectations of high economic growth.
• Low interest rate policy.
• Weak corporate governance on the part of banks.

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III. CAUSES OF THE BANKING CRISIS (contd)

• 2. Severe Negative Impact of Asset Price
  Deflation
• Rapid credit growth had been accompanied by a
  doubling of stock prices and a massive rise in
  commercial estate prices, particularly in major
  cities.
• A sharp increase in interest rates and the
  introduction of credit ceiling on bank loans to
  real estate-related activity led to the bursting
  of the asset price bubble.
• The bursting of the bubble created substantial
  losses for firms that held equities and had
  borrowed from banks with real estate as a
  collateral.
• This transformed overextended loans into
  non-performing loans, and the large build-up of
  capital investment and labor employment during
  the bubble period into excesses.
• Asset price deflation has continued for more than
  ten years.

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III. CUASES OF THE BANKING CRISIS (Contd)

• 3. Policy Failure to Contain the Problem Quickly
• Policymakers initially had a strong bias against
  the bubble and continued to suppress asset prices
  even after the price collapse.
• Hesitation in taking decisive measures for fear
  that it might touch off a banking sector panic.
• The initial approach was based on the expectation
  that a resumption of economic growth would
  restore financial health of banks and their
  clients.
• Keynesian fiscal policy sustained minimum growth.
• There was no domestic or external pressure to
  accelerate the resolution of banking problems.

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IV. IMPACT OF BANKIG DISTRESS

• 1. Collapse of the Traditional Convoy System
• Until the 1990s, the process for managing bank
  failure was largely ad hoc, based on the informal
  convoy system.
• Using its branch licensing authority, MOF
  encouraged stronger, healthier banks to absorb
  insolvent institutions through informal,
  administratively orchestrated, bank PA
  transactions.
• In addition, BOJ often provided liquidity
  assistance to prevent systemic crises.
• But it became increasingly difficult to persuade
  banks to provide assistance to other troubled
  banks because even relatively strong banks faced
  serious NPL problems.
• Major shareholders and firms associated with
  Hokkaido Takushoku Bank, Yamaichi Securities and
  Sanyo Securities refused to help them. Relatively
  strong banks also refused to provide assistance.
• Temporary nationalization of the Long-Term Credit
  Bank of Japan in October 1998 signified the end
  of the convoy system.

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IV. IMPACT OF BANKIG DISTRESS (contd)

• 2. Downsizing of Bank Business
• One response to the banking crisis has been
  further deregulation, rather than stopping it,
  along with the principle of Financial Big Bang,
  and the encouragement of mergers and
  consolidation.
• The temporarily nationalized LTCB was sold to
  foreign stakes.
• Commercial banks have been forced to rethink
  their business strategies by downsizing their
  operations
• -End of quantitative targets (maximization of
  deposit collection and loan extension)
• -Focus on core competency
• -Retreat from foreign operations

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IV. IMPACT OF BANKIG DISTRESS (contd)

• 3. Impacts on Monetary and Fiscal Policy
• Commercial banks with large NPLs have not been
  expanding loans, and indebted firms have had no
  appetite to borrow, and instead have been
  repaying their bank loans to reduce debt.
• Weaker monetary transmission mechanisms
• -Under the zero interest rate policy, BOJ
  switched to quantitative easing (March 2001)
  providing liquidity to the banking sector.
  Monetary base has been growing relatively fast,
  but M2CD has not been growing as fast (Figure
  5).
• -Absence of banks normal financial intermediary
  function weakens monetary policy transmission
  mechanisms.
• Fiscal worsening Rise in government spending,
  decline in tax revenue, large budget deficits and
  mounting public debt.

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V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND
ITS PROGRESS

• 1. Stabilization of the Banking System
• The banking sector was in systemic crisis in late
  1997 to 1998. The banking sector has been
  stabilized since then due to more decisive policy
  actions.
• Means of stabilizing the banking sector
• -Blanket deposit guarantee
• -Extension of emergency liquidity assistance to
  troubled banks
• -Financial assistance to promote mergers among
  troubled financial institutions
• -Decision to inject capital to weak but viable
  banks
• -Temporary nationalization of non-viable banks

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V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND
PROGRESS (contd)

• 2. Bank Restructuring
• Public recapitalization (March 1998, March 1999,
  May 2003). See Table 2.
• Recognition of NPLswith tighter loan
  classification and loan loss provisioninghelps
  not only identify the size of NPLs but also
  prompts faster NPL disposals
• Disposal of bank NPLs, close to 90 trillion yen
  in the last ten years. Despite disposals, bank
  NPLs have not declined fast due to the emergence
  of new NPLs (Table 3).
• Exit of a number of inefficient deposit-taking
  institutions.
• Establishments of public AMCs (RCC, IRC) has
  encouraged the carving out of NPLs.

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V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND
PROGRESS (contd)

• 3. Bank Business Strategies and Consolidation
• Consolidation of city banks into four major
  financial groups and one weak group (Table 4).
• -Mizuho Financial Group (January 2003)
• -Sumitomo Mitsui Financial Group (December 2002)
• -Mitsubishi Tokyo Financial Group (April 2001)
• -UFJ Holdings (April 2001)
• -Resona Holdings (December 2001).
• Banks strategic objectives
• -Gaining maximum market power in a niche market
• -Attaining economies of scale
• -Investing in IT
• -Investment banking, asset management, fee-based
  business

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V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND
PROGRESS (contd)

• 4. Linkages with Corporate Restructuring
• Corporate sector restructuring is the mirror
  image of bank NPL resolution. Resolution of bank
  NPLs requires real operational restructuring and
  revitalization of corporations.
• Market-based restructuringlike direct sales of
  NPLs to the marketis key.
• Three frameworks to accelerate corporate
  restructuring
• -Legal insolvency procedures (Table 5),
  particularly the Civil Rehabilitation Law (April
  2000)
• -A framework of voluntary out-of-court
  negotiations for corporate restructuringbased on
  the London rules of INSOLincluding debt-equity
  swaps
• -Restructuring through the RCC and IRC

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V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND
PROGRESS (contd)

• 5. Regulatory and Supervisory Reforms
• Overhauling of the regulatory system and the
  creation of the FSA (June 1998).
• Prudential norms
• -Loan classification and LLP tightened (Program
  for Financial Revival, Oct. 2002)
• -Quality of capitaltreatment of deferred tax
  credits
• -Prompt corrective action fully in place
• -After a delay, planned reintroduction of a
  limited (partial) deposit insurance in April 2005
• Resolution of 50 percent of NPLs within a year,
  and 80 percent of NPLs within two years.

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VI. CONCLUDING REMARKS

• The bubble in the late 1980s and its collapse
  were largely responsible for the emergence of
  NPLs and the banking sector problem over the last
  10 years.
• But the root cause of the problem lied in the
  lack of prudent risk management by banks.
• The government failed to tackle the problem
  because of underestimation of the seriousness of
  the problem optimistic expectations of growth
  sustained fiscal spending and lack of domestic
  hardship lack of domestic and external
  constraints.
• A more comprehensive framework for bank
  restructuring put in place since the 1997-98
  crisis temporary nationalization and subsequent
  sales of non-viable banks recapitalization of
  weak banks tighter bank regulation and
  supervision new institutions for bank
  restructuring.

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VI. CONCLUDING REMARKS (contd)

• Sufficient progress has been made stabilization
  of the banking system, restructuring and
  consolidation of bank businesses and new
  incentives for corporate restructuring
• Restoration of a healthy banking system requires
  adequate capital base and loan loss provisions
  reestablishment of profitable banking business
  prudent risk management.
• Recapitalization of banks using public money in
  itself does not resolve bank NPL problems.
  Sustained improvements of cash-flows and
  profitability are needed through better bank
  management and focus on core competency.
• The banking sector is largely solvent. The risks
  are concentrated in regional, vulnerable banks to
  weak local conditions and hikes of the long-term
  interest rate.