FRBSF Economic Letter
97-37; December 13, 1997
Financial Crises and Bank Supervision: New Directions for Japan?
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
The economies of East Asia have been buffeted in recent months by bouts
of speculative currency attacks, stock and real estate price declines,
and banking problems. Media attention has focused on Thailand, Indonesia,
Korea, Malaysia, and, most recently, Hong Kong. By far the largest banking
problem in the region, however, continues to be faced by Japan, where
in recent days, a major commercial bank and a securities firm announced
they would shut down operations. Japan was hit much earlier with a banking
and "bad loan" crisis, dating back to the collapse of the "bubble
economy" in 1990-92. Since that time the Japanese government has
been struggling, with limited success, to deal with its financial problems.
And recent declines in the Nikkei index, together with indications of
a weakening economy, threaten to make the bad loan problem worse. Why
has Japan failed to resolve its banking problem while several other industrialized
countries, facing similar or worse problems, settled them years ago? As
governments in other East Asian countries confront and search for solutions
to their own banking problems, lessons on how--and how not--to proceed
may be gleaned from the Japanese experience.
Bad loan problem
About seven years ago, the Japanese economy began to slide into a long
recession, leaving many financial institutions with nonperforming loan
problems; Cargill, et al. (1997) estimate that in 1995, nonperforming
loans countrywide totaled around 10% of GDP (6% of all loans). The primary
cause of the nonperforming loans was the fall in land prices that began
in late 1991; by the end of this year, many properties were worth only
half their peak values. The problem is compounded by a rise in nonperforming
commercial loans associated with the prolonged recession and weak recovery.
And it is further compounded by the fact that Japanese banks' large equity
holdings suffered as the Japanese stock market fell. The Nikkei 225 stock
price index reached its peak at 38,915 on the last business day of 1989,
and then tumbled to below 15,000 by the summer of 1992.
The bad loan problem remains large in magnitude. The official estimate
by the Ministry of Finance (MOF) is that banks, savings institutions,
and agricultural cooperatives were carrying 27.9 trillion yen ($232 billion)
in nonperforming loans, most of them linked to real estate, as of last
March. This official estimate is down substantially from just two years
ago. But private estimates are generally much higher, sometimes more than
twice the MOF figure, because of differences in measuring the value of
underlying assets and technical definitions of loan performance and concessionary
interest. More disconcerting is that the bad loan problem may be worsening
amidst new signs of weakness in the Japanese economy (slow growth in credit,
consumption, and output) and further drops in the Nikkei stock index (again
slipping below the 15,000 mark in mid-November 1997 before rebounding).
Forbearance: working out problem loans?
The MOF, the primary regulatory agency, was slow in reacting to the
nonperforming loan problem confronting financial institutions in the early
1990s (see, for example, Cargill, et al., 1997). The response to the bad
loan problem was a series of uncoordinated actions, proceeding on a case-by-case
basis. "Administrative guidance" was followed in most cases
to determine how each problem would be resolved, and in each case a great
deal of discretion was exercised by MOF officials. Indeed, this form of
discretion in setting and implementing policy is often identified as a
hallmark of Japanese bureaucratic prerogative.
The Ministry initially adopted a "forbearance" policy, allowing
financial institutions to hold nonperforming loans without special writeoffs
in the hope that the economy and the real estate market would recover
quickly. Financial disclosure and accounting rules also were changed to
allow stock losses to be deferred and to delay the effect of real estate
price declines on banks' reported assets, among other things. Starting
in 1991--for the first time in the postwar period--the authorities used
the resources of the Deposit Insurance Corporation (DIC) to assist mergers
of insolvent depository institutions with stronger institutions, though
only four assisted mergers took place between 1991 and 1993.
Smaller financial institutions with significant exposure to real estate
began showing signs of increasing distress in 1993, especially the jusen
companies (nonbank subsidiaries of financial institutions specializing
in housing loans). The MOF initially arranged a ten-year "rehabilitation"
plan for the jusen based on the expectation of a quick recovery
of land prices. When this failed to materialize, and with nonperforming
loans growing in size and number, the rehabilitation plan was quickly
abandoned.
Escalating problems
As the full extent of the financial problem became evident--even large
institutions were in serious trouble--Japans regulatory authorities were
forced to take a stronger approach. In 1995, the MOF closed some of the
lowest quality institutions and created a "bridge bank" that
would receive the remaining assets of failed smaller institutions (credit
cooperatives); this "bridge bank" was first called the Tokyo
Kyodo Bank and later was reorganized as the Resolution and Collection
Bank (RCB), modeled roughly on the U.S.'s Resolution Trust Corporation.
The MOF also allowed (or encouraged) large writeoffs by some banks and
closed seven of the jusen companies.
The first major bank failure occurred in late 1996 when the Hanwa Bank,
a large regional bank, was liquidated (not an assisted merger). This was
followed in 1997 by the officially assisted restructuring of the Nippon
Credit Bank (Japan's 17th largest bank), and the closing of Hokkaido Takushoku
Bank--the first city bank (that is, a large commercial bank) to close
its doors during the crisis.
These recent substantive measures have helped, but the fact that nonperforming
loans continue to be such an important issue in Japan draws attention
to delays in identifying and resolving the problem. The initial "forbearance"
policy, delayed response, and rather ad hoc approach to the nonperforming
loan problem in Japan has not worked well. Moreover, most of the burden
so far has been placed on healthy financial institutions to support problem
institutions through mergers, acquisitions, or injections of capital.
The policy of requiring healthy banks to help unrelated problem institutions
has been termed the "all Japan" rescue scheme.
The strong reluctance to commit public funds to liquidate insolvent
institutions has been a major obstacle in resolving Japan's bank problems.
The use of public monies was brought up by the government as part of the
jusen resolution plan in late 1995. This legislation was eventually
passed, but brought strong political opposition despite involving only
about $4.5 billion in public funds. This contrasts with the estimated
$145 billion committed by the U.S. government to resolve the savings and
loan crisis--a much smaller banking problem than Japan's--or even the
estimated $9.2 billion initially committed by the Swedish government in
1992 to recapitalize its banks and take over the bad loans during its
financial crisis.
It is noteworthy that the November 17 announcement of the bankruptcy
of Hokkaido Takushoku Bank was welcomed by the market, helping to push
up the Nikkei stock index almost 8% that day--the fourth largest gain
in its history. The problems of the bank were well known, and the announced
liquidation followed a failed assisted-merger attempt with another institution.
The announcement, however, was taken as a sign that the regulatory authorities
at long last are taking the necessary measures to find a final resolution
of a problem that has been casting a shadow over the whole Japanese financial
system for years.
New initiatives
Japan's approach to its banking crisis has raised concerns about how
the authorities are likely to respond if future problems arise, particularly
if financial deregulation brings greater competition to the market. In
the context of Prime Minister Hashimoto's financial reform plan, it was
emphasized that "bad loan disposal" must be implemented in tandem
with reform. The MOF has stressed that in completing financial reform,
the soundness of the financial system must be assured by the speedy disposal
of nonperforming assets of financial institutions and by the introduction
of new procedures to identify and manage problem institutions.
Recent legislation has set in motion a restructuring of Japan's financial
supervisory agencies (Choy 1997). The Japanese Diet passed legislation
last June giving final approval to create an agency tentatively named
the Financial Supervisory Agency (FSA) to supervise and inspect financial
institutions. The FSA is scheduled to open in July 1998. The new agency
will be under the direct control of the Prime Minister's office, including
the appointment of its Chief Officer, with the aim toward providing unified
supervision towards financial institutions, including agricultural, labor,
and nonbank institutions. The FSA will oversee banks, securities houses,
insurers, and some nonbank lenders that are currently supervised by the
MOF. The operations of the Securities and Exchange Surveillance Commission,
also currently controlled by the MOF, will be transferred to the FSA.
Beyond creation of the FSA, a study group was set up to investigate
procedures that would allow loan and bank problems to be handled as they
arise in a more transparent, systematic, and rapid fashion. The interim
report issued has called for an extensive set of new procedures, under
the rubric of "prompt corrective action" (PCA). These changes
are slated to be implemented in April 1998.
The interim report identified two major areas needing overhaul: evaluating
and auditing the position of financial institutions, and specific measures
for supervisors to follow in identifying, correcting, and possibly closing
problem financial institutions. The first part is designed to make more
transparent the true position of financial institutions and to strengthen
external auditing. In particular, the report proposes more appropriate
and timely allowances for loan losses and write-offs which are to be reflected
in financial statements, clearer rules on banks' own assessments of asset
quality, and more intensive external auditing of the accuracy of financial
statements.
The second part of the interim report on PCA outlines the role of supervisors
in measuring the position of financial institutions and dealing with problem
institutions. The method for calculating capital adequacy ratios would
be changed to follow international standards more closely. In terms of
system management, the proposal is to identify problem financial institutions
by the capital adequacy ratios which then trigger specific corrective
actions by the supervisors. Institutions with capital adequacy ratios
below 8% by the international standard are issued an order to formulate
a management improvement plan. Institutions with ratios below 4% are ordered
to implement specific corrective measures, and institutions below 0% are
ordered to suspend business operations.
Conclusion
The establishment of a new Financial Supervisory Agency and other measures
such as Prompt Corrective Action may help Japan avoid future bank crises.
The FSA appears to mark a new direction in Japanese policy toward financial
market supervision and regulation. The other proposed measures reviewed
here, if adopted, also would greatly enhance the transparency of the financial
position of Japanese banks and other financial institutions. And if the
Prompt Corrective Action measures are fully implemented, identification
of problems should be easier and corrective actions implemented more quickly.
However, Japan still has a long way to go to resolve its current banking
and nonperforming loan problems. Some progress was marked by closing or
restructuring a number of smaller financial institutions, including the
jusen. Now several large banks also have been closed or reorganized.
But public funding for liquidations and restructuring remains a problem,
as is the mechanism for taking over and disposing of the real estate collateral
underlying many of the nonperforming loans. The piecemeal, case-by-case
approach followed by the authorities in dealing with nonperforming loans
and particular banking institutions during the past seven years continues
to cast an unfavorable shadow over the whole Japanese financial system.
Michael Hutchison
Professor of Economics, U.C. Santa Cruz
and Visiting Scholar, FRBSF
References
Cargill, T., M. Hutchison, and T. Ito. 1997. The Political Economy
of Japanese Monetary Policy. Cambridge: MIT Press.
Choy, J. 1997. "Panels Issue Schematics for Financial Market 'Big
Bang'." Japan Economic Institute JEI Report 24B (June 27).
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
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