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pledging real estate as collateral. As the asset and property prices continued on their upward spiral, there was increased speculative activity. By the mid-1980s, the money raised was used to speculate in risky stocks, options, warrants, and the booming real estate sector.

In the period 1984 – 89, Japan issued a total of $720 billion in securities. The new equity financing was twice that of the USA, an economy twice its size which was experiencing a boom over the same period. Just under half were sold on the domestic market, mainly in the form of convertible debentures (and new share issues); the rest were sold in the euromarkets as low coupon bonds with stock purchase warrants55.

Banks and securities firms were enthusiastic supporters of zaitech behaviour. Some corporate loan business was being lost to the bond markets, but banks benefited from disintermediation through fee based ‘‘commissioned’’ underwriting. The rise in the stock market increased the value of their cross-shareholdings in keiretsu member firms. Lending patterns also changed. Hoshi and Kashyap (1999) report a dramatic increase in loans to small business and the real estate sector through the 1980s. The proportion of bank loans to property firms doubled between the early 1980s and early 1990s.

The regional and smaller banks were especially keen to lend to firms unable to raise finance through the bond market but in need of cash to finance their own share purchases. These marginal borrowers were charged higher loan rates and supplied ‘‘safe’’ collateral: real estate and/or equities held by the firm.

In the late 1970s and early 1980s, Japanese banks entered the global loan markets, competing with international banks to lend to developing countries. The objective was to increase market share, by lending to these countries at below market rates. Most foreign lending is denominated in US dollars. The resulting currency risk, if uncovered, is costly when the yen depreciates against the dollar. The 1982 Mexican crises hit the Japanese banks hard, but along with other global banks, they were persuaded by the IMF to reschedule the debt. The MoF also discouraged the banks from writing off these loans. It is worth noting not all the lending went to developing countries. Peek and Rosengreen (2003) report an eightfold increase in Japanese loans to the US commercial property markets between 1987 and 1992.

Bubbles add to uncertainty because it is unclear when they will burst. Asset management is made more difficult because of increased marginal borrowers on domestic and international markets.

Phase 2: The bubble bursts and prices collapse, a process that can occur within a few days, months or even years.

In 1989, a new Governor at the Bank of Japan, influenced by the Ministry of Finance, expressed concern that Japan’s economy was overheating and threatened by inflation. In Japan, like Germany, past episodes of inflation56 means any hint of inflationary pressure results in strong measures to combat it. In early 1990 the bubble was pricked by tighter monetary policy and a jump in interest rates. Chart 8.1 illustrates the sharp decline in the Nikkei 225. By September 1992, it was less than 15 000, 62% off its 1989 peak.

55Convertible debentures involve a bond issue where the investor has the option of converting the bond into a fixed number of common shares. Stock purchase warrants are like convertible debentures but the conversion part of the bond, the warrant, can be detached and sold separately.

56At the end of World War II and immediately thereafter, Japan experienced a burst of substantial inflation (a 20-fold increase in prices) relative to what they were used to.

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Property prices followed the Nikkei in a dramatic spiral downwards – by 1995, property prices were 80% lower than in 1989. According to the IMF (2003, p. 72), in 2002, property prices declined for their 12th consecutive year, by an annual average of 6.4%. Any hope of recovery in 2003 was dampened by the increasing supply of redeveloped office space coming onto the Tokyo market.

Zaitech holdings declined in value, with no change in firms’ loan obligations. Firms sold shares to cover loan repayments, leading to further falls in the stock market. Shares fell even faster for companies known to have extensive zaitech holdings. Many share prices fell below the exercise prices of the convertible debentures and warrants, meaning these bonds would not be converted into shareholdings, leaving firms to pay off bondholders once they matured.

Phase 3: When the firms that borrowed from banks to purchase the high yielding assets default on their loans, the outcome is a ‘‘crisis’’ in the banking sector, and possibly the financial system as a whole. Volatile foreign exchange rates may prompt a run on the currency. All contribute to recession or depression in the real sector of the economy. To date, there has been no currency crisis in Japan. A serious banking crisis which was left unresolved for several years has contributed to what the IMF (2003, p. 14) calls a ‘‘fragile’’ banking sector, with both stock and flow problems.

Box 8.2 illustrates the problems Japan has faced and summarises the key banking events and reforms. The box also shows Japan, albeit late in the day, took action characteristic of most countries experiencing a banking/financial crisis. These include:

žThe creation of a ‘‘bad bank’’ to improve the balance sheets of solvent banks by buying their poorly performing loans.

žClosure or nationalisation of banks – though few in number and relatively late in the crises.

žNew laws and procedures such as prompt corrective action to close banks, though a policy of too big to fail has also been adopted.

žIntroduction of blanket insurance coverage to stop runs on banks.

žRecapitalisation and new procedures designed to improve loan restructuring, provisioning and better corporate governance.

žBank mergers, again relatively late. By 2002, Japan had four mega bank groups: Mizuho Financial Group (Fuji, Dai-ichi Kango and Industrial Bank of Japan), Sumitomo Mitsui Banking Corporation (Sakura and Sumitomo Banks), Mitsubishi Tokyo FG (Bank of Tokyo and Mitsubishi Bank) and UFJ Holding (Sanwa and Tokai Banks). Since virtually all these banks were unhealthy at the time of merger, it was not possible to marry weak banks with solvent ones, unlike other countries. The first three mega banks rank in the top 10 world banks in terms of tier 1 capital, but all four reported negative ROAs and real profits growth in 2003.

Unfortunately, these actions have proved insufficient for dealing with the bank/financial crisis. A recent IMF (2003) report, 13 years after the onset of problems, refers to the ‘‘fragility’’ of the banking system. Why do these problems persist when, in most countries, similar policies have resolved the crises? The IMF report refers to the ‘‘stock and flow’’ problems of the banking sector and it is in this context that the discussion below explores the reasons for the prolonged crisis.

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Box 8.2 (Continued)

again, to April 2005. ¥17 trillion was injected into the fund to assist banks and to allow for 100% deposit insurance coverage.

žMay 2000: Deposit Insurance Law amended to allow for ‘‘systemic risk’’ exceptions. If the failure of a FI is deemed a threat to the stability of the financial system, the Prime Minister can call a meeting of the Financial Crisis Council, chaired by the PM. The DIC is then allowed to inject more capital, provide

additional assistance or acquire the bank’s share capital. In May 2003, the PM used the law for the first time and ordered the DIC to recapitalise the Resona Group (the 10th largest Japanese Bank by tier 1 capital according to The Banker, 2003) to bring its capital adequacy ratio above 10%. The recapitalisation included a revitalisation plan submitted by the bank which meant 70 senior managers would go, and salaries would be cut. This has been interpreted to mean that the largest banking groups are ‘‘too big to fail’’. For all other failing banks, the FSA can appoint a financial administrator to deal with the bank, including the disposal of assets and liabilities.

žThe FSA is actively encouraging mergers. By 2002, Japan had four mega bank groups: Mizuho Financial Group (Fuji, Dai-ichi Kango and Industrial Bank of Japan), Sumitomo Mitsui Banking Corporation (Sakura and Sumitomo Banks), Mitsubishi Tokyo FG (Bank of Tokyo and Mitsubishi Bank), UFJ Holding (Sanwa and Tokai Banks). It is hoped the mergers will encourage the cross selling of financial products such as mutual funds and insurance, achieve cost savings (through staff cuts, especially when there are overlapping branches, and by spreading IT costs) and improve corporate governance by getting rid of managers of unhealthy banks.

ž2002: The Government and Bank of Japan set up schemes to purchase bank equity.

ž2003: Industrial Revitalisation Corporation of Japan, established to encourage effective corporate restructuring. Japan Post was created with plans to reform or even privatise it.

8.4.3. Japanese Banks: The Stock and Flow Problem

The Banks’ stock problem is caused by a high percentage of non-performing loans, weak capital, and exposure to the equity and property markets, either directly through crossshareholdings, or through low value collateral, all of which lower the value of their assets. The contributory factors to the stock problem include the following.

žThe value of the equities held on the banks’ own books fell dramatically, there were large numbers of zaitech firms unable to repay their debt, and the value of collateral (equity and property) collapsed.

žEarly MoF policies discouraged banks from writing off bad loans, a critical mistake. For example, in 1991, non-performing loans were rising (evident from the large number of company failures) but banks reduced new reserves set against bad debts! According to Hoshi and Kashyap (1999, p. 27), provisioning began to increase but even in 1995, loan loss reserves covered just 52% of the bad debt of the major banks.

žThe FSA’s estimates of non-performing loans appear in Table 8.11.

If it is assumed the NPLs of healthy banks lie between 1% and 3%, Table 8.11 shows that banks in every sector are in trouble. The long term credit banks (LTCB) are at or close to 10% and the trust banks are not far behind. The rise of NPLs at city and regional banks in 2002 – 3 reflect the attitude on the part of the new FSA which, unlike the MoF in the early years, has pressured banks to provision for NPLs. However, there are several reasons for thinking these figures substantially underestimate the percentage of bad loans on the banks’ books. First, with such low interest rates, it is relatively easy for firms that are effectively insolvent to find the cash to service their debt. Second, the definition of NPLs omits

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information on pension liabilities, audited cash-flow statements, and the debt loans of subsidiaries.

Peek and Rosengreen (2003) provide evidence for much of the bank behaviour noted above. They employ a panel data set from 1993 to 1999, including firm level data which link each Japanese firm to their individual lenders. Together with other data, their econometric tests confirm three hypotheses. First, banks engaged in a policy of evergreening, that is, they extend new credit to problem firms to enable them to make interest payments, and thereby avoid or delay bankruptcy. This policy serves the interest of the bank because they can avoid provisioning for bad loans which would put additional strain on their capital requirements. Second, the incentive to evergreen increased if a bank’s capital ratio was approaching the minimum required ratio. Finally, corporate affiliations (e.g. keiretsu) increase the probability that the loan will be made and, the weaker the affiliated firm, the greater the likelihood of a loan being granted. The authors also confirm the presence of regulatory forbearance: the government, in the face of rising deficits and a public hostile to the bailout of banks, put pressure on the banks to behave in this way.

The Financial Supervisory Agency (see Box 8.2) recently began to encourage banks to evaluate loans based on the cash flows the borrowing firm is expected to generate. Banks agree a new repayment scheme and provision according to the net present value of the loan. Provided the estimated cash flows are accurate, this will improve the quality of a bank’s balance sheet and encourage more loan restructuring.

Another problem banks face relates to their substantial holdings of equity, arising from cross-shareholdings. The high value of the equities had provided a capital cushion because market value exceeded book value. The situation was reversed after 1989, when the dramatic decline in the stock market began. It is estimated that Japan’s hidden reserves fall to 0 if the Nikkei is below 13 000, which it has been for most of the new century so far. In 2001, banks were estimated to hold shares which exceeded their capital by 1.5 times. To deal with the problem, banks have had to adhere to new regulations:

žFrom September 2001, they must subtract any equity losses from their capital base, which will adversely affect their Basel ratios.

žSince 2002, banks have had to mark to market their equity holdings, even if these are showing a loss.58

žEffective September 2004, equity holdings cannot exceed their tier 1 capital.59

žOther accounting changes require bad corporate debts hidden in the books of subsidiaries to be added to bad debt provisions.60

Bank capital: manipulation has inflated the size of tier 1 and 2 capital. One example is Deferred Tax Assets, or credits against taxes in future income (IMF, 2003, p. 18). Most DTAs are due to losses carried forward: banks are borrowing from expected future profits

58To date, unrealised profits on equity holdings were reported on a mark to market basis but historical costs are used for unrealised losses.

59The Bank of Japan has a scheme to purchase up to 3 trillion yen of these holdings at market prices but will keep them off the market.

60Also, companies have to reveal unfunded pensions, which will reduce their creditworthiness.

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but only part of their losses are subtracted from capital. According to the IMF, DTAs make up about half the tier 1 capital, but cannot be used to meet losses should a bank fail. Also, low profitability has meant very little capital has been raised via new share issues. Instead, interest earning securities (e.g. preferred securities) have been issued and usually sold to other financial institutions. They are treated as tier 1 capital. Until banks are more profitable, it is unlikely banks will be able raise capital through equity issues. Finally, tier 2 capital is inflated by treating provisions for category II loans61 as part of tier 2 capital.

Banks’ flow problem

The flow problem arises because of poor profitability which prevents banks from writing off bad assets and raising new capital. The performance of Japan’s banks during the period 1998 – 2003 was quite poor. Over these 6 years, their ROA and ROE were, on average, negative for all but two years, unlike the other G-7 countries. In terms of financial strength, Moody’s rates Japanese banks between D− and E+, compared to A− to C+ for the other G-7 countries (Canada, France, Germany, Italy, UK, USA).62 Furthermore, as was observed in Chapter 5 (see Figure 5.9), Japanese banks’ cost to income ratios are much higher than is true for leading banks in other countries. This poor performance is likely to continue while the corporate sector remains weak, net interest margins are very low, and banks are crowded out from certain core businesses because of the subsidised post office and government financial institutions (see below). Consolidation (see below) should help to reduce competition and cut costs. However, while the banks’ performance remains poor, it will be difficult to raise capital through equity issues.

Other issues

The shinkin credit associations, credit unions and cooperative movements are very small, and most are exempt from regulation. But there are about 1700 all together (see Table 8.12) with total assets in the region of ¥124 trillion ($1.1 trillion). As mutual firms, they cannot raise finance through share issues. Local coops make loans to farms and fishing concerns. Farmers are net savers, and about two-thirds of their deposits are passed to the 47 shinren (prefectural lenders) or the national lender, the Norinchukin Bank. Though Norinchukin appears sound, local shinren approved loans to property developers, non-bank affiliates of big banks and speculators in the stock markets during the 1980s. The number of shinren reporting losses is unknown, but it is thought to be very high. Likewise, agricultural coops are in serious trouble.

Life insurance firms are also in trouble. Nissan Mutual and Toho Mutual, two big life insurance firms, failed in 1998/99. The public reaction was to cancel policies. Four more went bankrupt in 2000. Under Japanese law, once bankrupt, firms can reduce annual payouts and the amount paid out on maturity. Mergers and demutualisation are other possible options.

61Category II loans are loans which need special attention.

62Source: IMF (2003), p. 14 and table 4 in Appendix II.

Government financial institutions consist of the Development Bank of Japan (25 branches, 55.6 employees per branch), Japan Bank for International Co-operation (29 branches, 30 employees per branch), Finance Corporations (257 branches, 35 employees per branch).

Source: IMF (2003b), table 1, adapted by author.

Tax rules required firms to offer pensions which guarantee a minimum return, typically 2.75% over 8 years.63 The ‘‘5-3-3-2’’ rule64 (lifted in 1997) forced funds to invest in government bonds, property and the stock market. Bond yields have declined with the fall in interest rates, and are now below 2%. Thus, pensions are underfunded with very low rates of return. By one estimate, these firms have made losses since 1992.65

Non-life insurance firms do not face difficulties because most of their liabilities are short term, so they were limited to investing in cash instruments. In 2001, insurance markets will no longer be segmented. The problems of the life insurance sector may be alleviated

63The norm in western countries is a contributory plan: inputs are defined and the final pension payout will depend on portfolio returns.

6450% of funds to be invested in safe assets, less than 30% in shares, less than 30% in foreign currency denominated shares, and less than 20% in real estate.

65The Economist, 2/9/00, p. 98.

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The Japanese are very big savers compared to the rest of the world. Total deposits as a percentage of GDP rose from 1.58 to 2.06 between 1983 and 1996. By contrast, in the USA, they were 0.57, falling to 0.42 in 1996. The US figures are replicated by other OECD countries, though they tend to be a bit higher, in the region of 0.52 and 0.67 (1997 figures).68 However, there is a need to channel some of these savings away from Japan Post to banks, and into the new investment trusts (similar to mutual funds), which the banks and insurance firms have been allowed to sell directly to the public since 1998. Hoshi and Kashyap (1999) report on forecasts made by the Japan Economic Research Centre. 59% of household assets were in cash and deposits, and the JERC expects them to fall to 45% by 2010 and 35% by 2020. However, the effects of reduced deposits will be partly offset by an increase in banks’ revenues from the sale and management of the equivalent of mutual funds.

Ten Government Financial Institutions, nine of which specialise in some form of lending, crowd out private sector loans. For example, the Government Housing Lending Corporation has 30 – 40% of the mortgage market in Japan. Small and medium-sized enterprises can borrow from any one of three GFIs created to supply them with loans. The Japan Small and Medium Enterprise Corporation insures guarantees of loans to SMEs made by the private sector. It is estimated that four of these GFIs have 20% of the market share in loans to SMEs. Large corporations can borrow from two of these GFIs, which have a market share of about 19%. The GFIs, other public corporations and local governments are funded by transfers from postal savings and life insurance.69 There are plans to reform Japan Post and the GFIs, but progress is painfully slow.

Japan’s Prime Minister announced a series of financial reforms in ‘‘Big Bang’’, 1996 – see Box 8.2 and the appendices at the end of this chapter.70 Despite all of these reforms there has been little in the way of obvious changes in the financial structure. Compare Table 8.12 with the pre-Big Bang Table 8.1. There has been no significant reduction in the number of city, foreign, savings and loans (shinkin banks), and regional banks. The difference is that these firms may now be part of financial holding companies, and therefore can expand into new areas of business. However, a major drawback is the existence of Japan Post (compare its branch outlets with those of the city and regional banks) and the government financial institutions in their current form, which are subsidised and have a notable market share of deposits, mortgages and loans to SMEs and corporations, making it difficult for banks to penetrate these potentially lucrative markets. Unlike banks in other industrialised countries, Japan’s private banks have little opportunity to profit from many aspects of retail and wholesale banking.

Japan’s macroeconomic situation

The slow pace of reform together with the failure of policy makers to close insolvent corporations and banks contributed to a serious downturn in Japan’s macroeconomy. The

68Source: Hoshi and Kashyap (1999), table 10.

69Via the Fiscal and Investment Loan Programme.

70The Big Bangs in New York (1970s) and London (1980s) took place in comparatively robust economies with healthy financial firms. Neither of these conditions applied to Japan when its version of Big Bang was announced in 1996.