JAPANESE DEREGULATION WHAT YOU SHOULD KNOW JAPAN’S FINANCIAL DEREGULATION: Prime Minister Ryutaro Hashimoto announced that his government would undertakean extensive deregulationof Japan’s financial system by 2001- a proposal likened by senior officials to the “Big Bang” financial deregulation in theUnited Kingdom more than a decade ago. The exact nature of these reforms, the timetable for implementation, and indeed whether the reforms will be as sweeping as promised, is still uncertain. The fundamental changes proposed, even were they togreatly benefit the Japanese economy as a whole, would necessarily entail losers as well as winners. And the potential losers,at present protected (by regulation) from market competition in Japan’s compartmentalized financial-services industry, arelikely to vigorously oppose change. Financial deregulation in Japan has been on the agenda for many years, proceeding onlygradually, and some skeptics argue that a sense of d j vu surrounds the present push for deregulation as well. Japan’s financial system, however, is at a juncture today which is not comparable to any other episode during the past 45years.
Stress in the Japanese financial system, especially failure to quickly resolve the non-performing loan problem, continuesto hold back the economy and has stagnated a large part of the real estate market. And the shortcomings of the existingregulatory and supervisory structure, pit against vastly different financial institutions (and markets) than just 15 years ago, isreadily apparent. Market forces and competition among financial institutions make the existing financial structure incompatiblewith Japan’s regulatory and supervisory structure. For these conflicts to be resolved, reform is necessary. Hence, economic aswell as political pressure for fundamental reform will continue even if the present wave of popular opinion against Japan’sfinancial institutions and regulators, especially the Ministry of Finance, wanes. Although there is conflict between the existing financial system and regulatory structure, changes in regulatory and supervisorypolicy would likely help resolve this conflict. One proposal on the table at this writing is to form a new agency to inspect andsupervise banks and other financial institutions, taking this responsibility in large part from the Ministry of Finance.
... level that compares well with other countries. Japan's labor market boasts an abundance of highly skilled human resources ... advanced chip technologies, telecommunication goods and services, new financial instruments and services). These products are appearing and changing ... benefits and choice, but it also promotes structural reforms by introducing new technologies and management expertise, maintaining ...
Whateverthe ultimate division of responsibilities among the Japanese government bureaucracy, however, our research suggests that acentral element to any successful reform is the introduction of a new policy approach to deal with the problems of regulatorydelays, moral hazard and inadequate funding to deal with insolvent financial institutions burdened with non-performingloans. A new approach should be based on a more explicit and transparent accounting, supervisory and regulatory framework.A new institution handling regulatory and supervisory responsibilities may facilitate introducing and implementing a new policy,but the process itself as opposed to the specific institution taking responsibility for it is most important for a successful reform. A review of the contribution of financial liberalization, greater market competition and changes in the flows of funds to theasset-price bubble in Japan illustrates the basic conflict between Japan’s financial system and its current regulatory andsupervisory structure. These fundamental changes in the financial system occurred in the 1970s and 1980s withoutcorresponding changes in regulatory and supervisory policy. The burst of the bubble in the 1990s, resulting non-performingloan problem, and inadequate response by the regulatory authorities, highlight why financial distress in Japan became sopronounced and has had such detrimental effects on the economy.
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Regulatory reform is necessary since thealternative-reversing past liberalization moves, re-regulating the economy, and maintaining tight administrative guidance over ahighly segmented financial system-is not compatible with Japan’s integration into increasingly open international financialmarkets. Financial Deregulation and the Bubble Economy In the second half of the 1980s, asset inflation was evident in many countries, though not of the same order of magnitude as inJapan. Indices of real asset prices for 13 industrialized countries consisting of equity, residential real-estate, andcommercial-real-estate components, illustrate a broad-based process of asset inflation in the second half of the 1980s (Borio,Kennedy, and Prowse, 1994).
The international character of asset inflation suggests common explanatory factors. The coincidence of financial liberalizationand asset inflation and deflation has led a number of observers to argue liberalization played a major role in the financialdisruptions of the 1980s and in the problems that the 1990s inherited from the boom-and-bust period. This view is rooted inthe traditional argument that unregulated and competitive banking is inherently unstable in the absence of governmentsupervision. In the context of liberalization in the 1980s, the removal of binding portfolio constraints permitted banks and otherdepositories to adopt more riskier investment and loan portfolios, including the adoption of high loan-to-value ratios. Relaxation and removal of various constraints on portfolio activity, especially for depository institutions, played an importantrole in the broad-based asset inflation.2 Banks also had incentives to adopt riskier loan and investment portfolios. Banks,directly or indirectly, provided imprudent levels of credit to real-estate and equity markets in an effort to offset declining profitmargins and declining market shares and to maintain the franchise value of commercial bank charters (supported in the past bya regulated and administratively controlled financial environment).
A number of special features of the Japanese financial system in the mid-1980s made asset inflation more probable in thecontext of a newly liberated financial structure and accommodating monetary policy: First, market participants had more portfolio flexibility than they had ever had in the past. This is especially true for smalldepositories; like the American savings-and-loan institutions during the 1980s, small Japanese credit-union-type depositoriesaggressively pursued lending in speculative real estate ventures during the bubble phase, and, like their U.S. counterparts, didso without oversight. Second, the shift to a slower growth path after the first oil-price shock in 1973 reduced the corporate sector’s reliance onbank credit and services. As a result, banks sought out new markets outside traditional corporate finance and were willing toassume new and often higher risks for which they had little previous experience. Table 1 illustrates the increased bank lendingto real estate during the bubble phase and Figure 1 illustrates the distribution of funds into real estate lending. Third, the main bank system of industrial organization began to unravel in response to financial liberalization, which in the past,had served as an effective system to evaluate and monitor risk. No widely available financial-disclosure framework wasavailable to replace the main bank system. Fourth, despite a common perception that Japanese banks were subject to a Glass-Steagall-type rule, they in fact haveconsiderable authority to directly purchase and hold equities, allowing bank credit to flow easily into equity markets. Inaddition, “hidden reserves” of banks were tied directly to the fortunes of the stock market (Table 2).
... interest rate and financial markets wither away. o Hyperinflation - It is an extremely rapid inflation whose impact on real output and employment ... cause some banks to close as well. However, prices are only cut if recession becomes severe. As discussed above, inflation is present ... money could be used for speculating in paper assets rather than spending on real goods and services. It is indeed most ...
Fifth, the regulatory monitoring system lagged behind market developments and “administrative guidance” could not keep pacewith the fast changing financial environment. Sixth, complete deposit guarantees encouraged risk taking at the very time the Bank of Japan provided the liquidity andfinancial liberalization provided the asset-diversification powers. The risk-incentive nature of government deposit guarantees or the “moral hazard” problem of government deposit guaranteesalso helps to explain the coincidence of asset inflation and financial liberalization in Japan and elsewhere.3 The liberalizationprocess in the 1980s in most cases failed to change the existing system of government deposit guarantees that had beendesigned for a more regulated and administratively controlled financial environment. As a result government deposit guaranteesprovided incentives to assume risk, while at the same time, regulatory and market innovations permitted depositories tomanage and assume more risk. In addition, regulatory authorities responsible for administering the government depositguarantee system were subject to perverse incentives in how they dealt with troubled institutions that in turn, encouragedgreater risk taking on the part of depository institutions.
... intervention, the financial institutions are becoming more market oriented. While still offering a variety of deposit accounts and loans, banks have now expanded ... and services. Consumers also attempt to gain a relationship between price and value. Traditionally, there have been two mechanisms available that ...
Financial Liberalization, Other Fundamentals or Bubbles? Financial liberalization and lack of adequate supervision was only one of several factors contributing to asset inflation. Table 3summarizes the set of factors that generated the asset price bubble, and the consequent non-performing loan problem.Considering the available evidence, the asset inflation phase of the second half of the 1980s can be characterized in thefollowing terms: The initial jump in stock and land price during 1985-86 was most likely related to changes in fundamentals.Aggregate productivity gains in Japan were very strong at the time. Demand for real estate, particularly in the Tokyo area,increased significantly. Expansionary monetary policy pushed interest rates to very low levels. Financial deregulation, changes in the flows of funds, and the increased risk-taking activity of banks also played a role at thebeginning of the run up in asset prices, but whether these factors should be characterized as fundamental determinants orspeculative activities is somewhat problematical. On the one hand, this activity is rationale from the point of view of financialinstitutions in the sense that they aggressively expanded into real estate business given newly expanded powers over assetallocation, changes in traditional business relationships, and so on.
On the other hand, financial deregulation combined with laxsupervision clearly allowed expanded lending into real estate on a speculative basis. Indeed, at some point, probably in late 1986 or 1987, the asset inflation process appeared to become a speculative bubblewith little restraint either from financial institutions or the regulatory authorities. Expectations of asset price increases fed uponthemselves and price/dividend and price/rent ratios increasingly deviated from fundamental values until the crash in the early1990s. Speculators during the asset inflation typically thought that even though the “levels” of stock and land prices wereabnormally high and would eventually fall, further investment was warranted as long as other investors thought prices wouldcontinue to rise. Many felt that they would be among the first to sell their asset holdings, realizing large capital gains, when themarket started to fall. This kind of behavior has been variously characterized as stochastic bubbles, herd instincts, momentumtrading, and bandwagon behavior. Burst of the Bubble, 1990-95 Asset prices declined rapidly in the 1990-1991 period. The Nikkei 225 stock price index reached its 38,915 peak on the lastbusiness day of 1989, and then tumbled.
... hand consumer loans are also getting popular these days, but are considered costly and risky for a bank as the financial situations of ... a pledge of certain borrower assets as collateral behind a loan, which serves two purposes. First that the bank has the right to ... time. Moreover his income level and valuable assets must be sufficient to reassure the loan officer that the customer has the ability ...
By October 1, 1990, the Nikkei stood barely above 20,000-declining almost 50percent in nine months. The Nikkei 225 index fell below 15,000 by summer 1992, and only broke the 20,000 point again inearly 1996. Land prices began to fall in late 1991 and, by 1995, prices were frequently only half of their peak values. At thattime, the typical land price was similar to that prevailing 10 years earlier. Sources of Decline A combination of policy actions and the self-correcting mechanism of the speculative process (deflating the bubble) wereresponsible for the asset price decline. By mid-1989, the monetary authorities became fully aware of, and concerned about,asset price inflation and started to raise interest rates. The Ministry of Finance also introduced several measures to slow landprice rises. The Iraqi invasion of Kuwait on August 2, 1990 further weakened the world economic outlook and the prospectsfor oil-dependent Japan in particular. Furthermore, once the decline in asset prices began, banks had an incentive to reducelending for real estate and other purposes. When the Basel risk-based capital ratio was negotiated in 1988 as an internationalminimum standard for banks with international businesses, Japanese banks were allowed to count 45 percent of their equityholdings as part of their tier II capital.
As the value of these equities were devoted meeting capital asset requirements, the costof capital increased, reducing the incentive of banks to make loans and contributing to the drop in credit expansion. Despite these factors, the most important reason for the collapse in asset prices was the self-correcting mechanism inherent instochastic speculative processes. Expectations of further price declines generated selling which in turn led to price declines.During the spring of 1990, for example, the Nikkei futures tended to lead the decline in cash markets. In fact, this wasresponsible for the view that futures transactions were making the stock market too volatile, and led to tightening of marginrequirements in the Nikkei futures market in Osaka in 1991.4 Non-performing Loans, Jusen Problem And Regulatory Inertia Asset deflation in the early 1990s dramatically affected the profitability of Japanese financial institutions, leading to seriousconcerns over the stability of the entire financial system. Deterioration in the quality of loans to the real estate sector was theprimary problem, but was compounded by the drop in the value of banks’ large equity holdings and growing loan problemsassociated with a prolonged recession.5 The Ministry of Finance, as the primary regulatory agency, was slow in reacting to the non-performing loan problemconfronting financial institutions. After the initial sharp decline of stock and land prices in 1991-1992, the Ministry of Finance
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first adopted a “forbearance policy,” allowing banks to hold non-performing loans without special write-offs, in the hope of aquick recovery of the economy and the real estate market.6 However, smaller financial institutions with large real estateexposure began showing signs of distress in 1993, soon followed by even larger problems for jusen or housing loan companies(non-bank subsidiaries of financial institutions specializing in housing loans).
The Ministry of Finance arranged a ten-year”rehabilitation” plan for jusen at that time. Rather than recognizing loan losses, however, the plan was predicated upon a landprice recovery. When land prices failed to recover, and with non-performing loans growing in size and number, therehabilitation plan was quickly abandoned. As the financial crisis unfolded, Japanese regulatory authorities launched a new approach to resolve these problems in 1994and 1995. The Ministry of Finance closed some of the lowest-quality institutions, created Tokyo Kyodo Bank as a bridgebank that would receive the remaining assets of failed smaller institutions, allowed (or encouraged) massive write-offs by somebanks, and made a decision to close down the jusen companies. An infusion of public funds, proposed for the first time in the1996-97 budget, was earmarked explicitly to cover the costs of closing seven jusen companies, and a variety of othermeasures where enacted in the wake of the non-performing loan and jusen problem. The Problem of the Jusen Companies The jusen companies were created in the mid-1970s as subsidiaries of banks, securities firms, and life-insurance companies.At that time, banks were concentrating on corporate lending, and were not generally interested in expanding their operations tohousehold lending, either for mortgage or consumer credit.
The jusen companies initially expanded to provide consumer credit,and much like consumer finance companies in the United States, borrowed from other institutions since they were notpermitted to accept deposits. As the corporate sector reduced their dependence on bank credit after 1975, however, banksbegan to turn to consumer finance as new lines of business, and in the 1980s became aggressive lenders to individuals. Inresponse to the aggressive bank competition for individual loans, jusen companies turned to real estate lending in the secondhalf of the 1980s to substitute for the lost consumer lending business. In April 1990, the Ministry of Finance introduced guidelines to banks to limit total lending to the real estate sector; however,jusen lending was exempted from this regulation. During the 1990-91 period jusen lending increased rapidly as a result offunds provided by agricultural cooperatives and their prefectural federations. Concerns over the asset quality of jusen wereraised as early as 1992 and a ten-year rehabilitation plan was arranged for the seven jusen companies7 in the spring of 1993.Lending to jusen was restructured so that “parent” banks (jusen’s major shareholder) were required to reduce the interest rateon outstanding loans to zero, other banks (non-parent banks that lend to the jusen) were required to reduce the interest rateon outstanding loans to 1.5 percent, while agricultural cooperatives (and their prefectural federations) were to receive 4.5percent interest income from jusen.
The arrangements were designed to provide liquidity to jusen until the expected future recovery in land prices made it possibleto pay off the outstanding loans in ten years. Land prices, however, continued to fall and non-performing loans held by jusenrose dramatically and for all practical purposes the rehabilitation plan itself became bankrupt. The Full Magnitude of the Jusen Problem The jusen problem became the focus of intense policy debate in 1995 and even overshadowed the non-performing loanproblem of the banks. In August 1995, the Ministry of Finance conducted a special examination of the jusen problem. Of thetotal 13 trillion of jusen assets, non-performing loans were estimated at 9.6 trillion, of which, 6.4 trillion was consideredunrecoverable and 1.2 trillion was considered a possible loss. This is more than a quarter of all losses incurred by financialinstitutions to date. The Ministry of Finance and the suppliers of funds to jusen companies agreed to dissolve the seven housing-loan companies,and in July 1996 the Housing Loan Administration was established to assume 6.4 trillion of unrecoverable loans extended tofailed jusen companies. Financial markets in the summer of 1995 became increasingly concerned about the burden sharing of the jusen losses amongbanks and other financial institutions that further reduced the credit worthiness of Japanese banks. Politicians and ministryofficials suggested that banks should shoulder more than a pro rata share of jusen losses. The precedent for this approachhad already been set when banks were required to provide a more than pro rata share in schemes for dealing with failinginstitutions in July and August of 1995 (Cosmo Credit Cooperatives; Kizu Credit Cooperatives; and Hyogo Bank).
Banksunrelated to these institutions were asked to contribute to the loss sharing scheme by contributing capital or makingbelow-market-rate loans to banks that assumed the assets of the insolvent institutions. These request were rationalized on thepublic good characteristic of the financial system and the need to maintain stability. The policy of requiring unrelated banks tocontribute directly to bail out schemes was referred to as the “all-Japan” rescue scheme. Uncertainty over future bank losses because of uncertainty over the specific jusen resolution scheme and degree of the”all-Japan” component, however, led to a downgrading of Japanese banks’ credit worthiness. The perception of increased riskin Japanese banks at large resulted in a “Japan premium” in the Euro-dollar market – a premium over the London interbankinterest rate (LIBOR) required of Japanese banks. The Japan premium appeared in late July to mid-August of 1995, andpersisted for several months, even though the Ministry of Finance attempted to assure the market by announcing a completedeposit guarantee. Regulatory Response to the Non-performing loan problem The first official responses to the non-performing loan problem were a series of specific uncoordinated actions predicated on ashort recession and rapid recovery of asset prices.
On August 18, 1992 the government announced a temporary rule changeto allow corporations to defer reporting stock portfolio losses until the end of the fiscal year (March 1993); permitted otheraccounting innovations that delayed or concealed the impact of stock and land price declines on reported assets; allowedbanks, in special cases where a loan default would have adverse social effects, not to report interest concessions as taxableincome (Packer, 1994); directed the Postal Life Insurance System to support the stock market via funds provided to trustbanks; postponed sales of government-held shares of Nippon Telegraph and Telephone and Japan National Railways; usedadministrative guidance to encourage institutional purchases of equities and discourage institutional sales of equities; andprovided less than candid estimates of the magnitude of the non-performing loan problem.8 These actions had little impact on the downward trend in asset prices and deterioration of the financial system. More specificand aggressive actions followed. These will be considered more or less in chronological order. Cooperative Credit Purchasing Company The Cooperative Credit Purchasing Company (CCPC) was the first visible effort to deal with the non-performing loanproblem. The CCPC was established in late 1992 and commenced operations January 1993. The CCPC consists of thepooled funds of 162 banks and cooperatives with the active encouragement and involvement of the Ministry of Finance. TheCCPC purchases a real estate loan at a price determined by a panel of experts with the institution selling the loan providing thefinancing. The CCPC then sells the collateralizing real estate and any difference between what the CCPC paid for the loan andthe selling price will be charged to the institution originally selling the loan. The CCPC from the beginning was viewed with skepticism (Choy, 1992; Salomon Brothers, 1992).
There were concerns theplanned loan purchases would represent only a small percentage of the non-performing loans, that self-financing requirementlimited access to only the strongest banks, that only the best of the non-performing loans would be sold to the CCPC anddelay the inevitable adjustment and, that since property management is retained by the original borrower and incentives tocooperate are unclear. These concerns remain despite over two years of operation during which the CCPC purchased 8.7 trillion of loans at facevalue (Table 4).
To indicate how much bank assets have deteriorated Table 4 also indicates the amount paid by the CCPC.The average loss ratio from March 1993 to May 1995 is 55.4 percent. The critical issue, however, is to what purpose theloans have been purchased and how does the CCPC plan to dispose of the loans? Packer (1994) investigated both questions. The CCPC now appears to have been set up primarily to provided accelerated taxbenefits to the large banks without requiring the banks to directly write off losses and acknowledge the losses in their publicreports. Sales of CCPC loans have been only a fraction of total holdings and there is concern that revenue from loan sales andrental income from properties will be insufficient to repay interest to the funding banks at market rates. The Resolution and Collection Bank The Tokyo Kyodou Bank was established in March 1995 to assume the assets of several failed credit cooperatives. The Bankwas reorganized in September 1996 into the Resolution and Collection Bank (RCB), which was loosely modelled after the USResolution and Trust Corporation. The track record of the CCPC suggests that the RCB will have a difficult time liquidating bad loans. Many of these loans aretied to a real estate market that remains depressed as of early 1997.
As of this writing the CCPC has sold only a fraction ofthe loans it has assumed. This is not impressive since the CCPC purchased the best of the non-performing loans. Thedepressed real estate market, the slow pace of economic recovery, and the lack of a well-developed foreclosure andbankruptcy procedures make it difficult to dispose of non-performing loans. It is possible that the CCPC, the Housing Loan Administration Corporation, and the RCB will end up being a form offorbearance- merely new warehouses for bad loans, when the Ministry of Finance really needs a garage sale. Assisted Mergers and the Deposit Insurance Corporation In 1991, the regulatory authorities for the first time in the postwar period officially assisted mergers of insolvent depositoryinstitutions with stronger institutions using for the first time the resources of the Deposit Insurance Corporation (DIC), Japan’slargest of two deposit insurance agencies.9 The DIC was established July 1971 with membership mandatory for city banks,regional banks, member banks of the second association of regional banks (sogo banks prior to 1989), trust banks, long-termcredit banks, shinkin banks, credit cooperatives, and labor banks.
Prior to 1991, the DIC had never needed to paydepositors, though there are claims the Ministry of Finance arranged several unpublicized “rescue mergers” without DICassistance. Since 1991, however, the DIC has publicly assisted a small number of problem institutions and two of the more recentlyassisted institutions exhausted the reserves of the DIC.10 The details of these assisted mergers, examined in Cargill, Hutchisonand Ito (1997), reveal a disturbing pattern about the ability of Japanese regulatory authorities to effectively administer depositguarantees and limit “moral hazard”. The DIC has had a turbulent record in its short history. The first 20 years were uneventful and few regarded the DIC as animportant component to the deposit guarantee system in Japan, though of number of commentators mentioned potentialproblems with a poorly funded deposit insurance agency (e.g., Cargill, 1985; Ito and Ueda, 1993).
Since 1991, however, theDIC has become a focal point of concern for two reasons: first, bailouts in late 1995 rendered the DIC insolvent11 andsecond, the approach to assisted mergers imposed few penalties on shareholders and none on depositors. Resolution of the Jusen Problem and the Use of Public Money In December 1995, the government proposed a resolution plan for the seven insolvent jusen companies which was passed bythe Diet spring 1996. Of the 13 trillion assets of the seven jusen companies, 6.4 trillion was an immediate loss (primaryloss), 1.2 trillion was a “possible loss” (secondary loss), 2.1 trillion was non-performing but possibly recoverable, and 2.5trillion was a normal or performing asset. The primary loss of 6.4 trillion was to be borne by banks and life insurancecompanies, by agricultural cooperatives as a gift12, and public spending by the government. The remaining assets are assumedby the so-called Jusen Resolution Corporation. The secondary losses will be dealt with in the future from special accounts. The plan has two problems. First, burden sharing was not equitable and reflected the political strengths of the agriculturalsector in Japan.
The plan is clearly lenient to the agricultural cooperatives and reflects the strength of a the farm sector in the inthe political system. Agricultural interests are disproportionally large because population per representative is much smaller inrural districts compared with urban districts. In addition, rural residents are generally more politically organized than urbanresidents, and consistently have higher turnout rates at elections. The strength of farming interests was revealed, for example,during the debate over sharing the burden of costs for he financial crisis. It became public the Banking Bureau Director General(of the Ministry of Finance) had secretly signed a memorandum of understanding with his counterpart at the Ministry ofAgriculture, Forestry and Fishery promising the Ministry of Finance’s full backing of agricultural cooperatives’ lending to jusencompanies.13 The heavier burden on banks also reflected the public perception that “founder banks” (banks that had set up jusen assubsidiaries) had a direct involvement in jusen operations. Founder banks provided staff to manage operations and maintainedthe business relationships with the jusen in the form of referring potential borrowers. These turned out to be high riskcustomers.14 Second, although the proposed amount of public funding was small compared to the magnitude of the non-performing loanproblem, the political opposition to using tax-payer funding was strong. The resolution plan will spend only 685 billion ofpublic funds in filling the gap between the