FRBSF Economic Letter
2001-06; March 9, 2001
The Return of the "Japan Premium": Trouble
Ahead for Japanese Banks?
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.
In January of 2001, overseas financial markets saw the re-emergence of
the "Japan premium," a term used to describe the extra interest
charged on offshore loans to Japanese banks relative to similarly risky
banks from other developed countries. So far, the magnitude of the Japan
premium has been small, never exceeding 0.05% and 0.07%, depending on
the bank examined.
However, the return of the Japan premium recalls the turbulent mid-to-late
1990s, particularly the fall of 1997, when the premium increased rapidly
in response to a series of failures of banks and other major Japanese
financial institutions. Moreover, these premia have been reported for
the larger Japanese banks, such as Bank of Tokyo-Mitsubishi and Fuji Bank.
The closure of one of these banks would be extremely unlikely, as it would
have adverse implications for the Japanese payments system. As a consequence,
in reporting these premia the Nihon Keizai Shimbun speculated that
the premia charged to other Japanese institutions were likely to be higher.
In this Economic Letter, I examine the reasons behind the
existence of a premium paid by Japanese banks and their implications for
the future performance of the banking industry. I also review the historical
record concerning the events that occurred the last time that Japanese
banks were forced to pay a premium on their borrowing. I conclude that
the small size of the current Japan premium suggests that the perceived
risk of extending funds to Japanese banks is not as high as it was in
1997. However, this does not necessarily imply that the risk of failure
for Japanese banks has completely disappeared. It could instead mean that
creditors of Japanese banks believe there is a high probability that their
debt will be serviced even in the event of a failure by their borrowing
bank.
The economics of the Japan premium
Offshore loans to a Japanese bank are not backed by any formal guarantees
of payment in the event of a failure by that bank. As such, those loans
will carry an additional risk premium. Domestic Japanese depositors do
not charge a premium on lending because their deposits are almost certain
to be guaranteed, even in the event of a failure.
This premium reflects two components: the probability that the bank will
fail and the expected returns to creditors conditional on bank failure.
An increase in either of these components would act to increase the premia
charged to Japanese banks overseas.
The first component will be directly affected by the financial strength
of a borrowing bank. By definition, the more financially sound a bank
is, the less likely it is to become insolvent. However, given bank financial
strength, both of the components also can be affected by government policy.
First, to the extent that bank regulators are reluctant to close insolvent
banks, a bank failure may be postponed beyond the point at which a given
loan comes due. This reduces the probability of default for the duration
of the loan, implying that creditors may be left whole even though the
underlying borrowing bank is insolvent. Even if failure does occur before
a loan is completely serviced, the delay will increase the number of payments
the bank makes and therefore the return on lending.
Second, to the extent that the government is expected to shield unsecured
creditors from losses in the event of a bank failure, the expected returns
to this class of creditors conditional on a bank failure will also increase.
This will decrease the premia charged to borrowing banks as well. Note
that this depends on the government's expected ability to shield
lenders from losses in the event of default, and not just on its expected
willingness to do so.
The offshore premium faced by a borrowing Japanese bank is therefore
going to be a function of both the true economic characteristics of that
bank and the expectations concerning government intervention in the event
of its insolvency.
The emergence of the Japan premium
in the 1990s
To appreciate the degree to which government policy can influence the
Japan premium, one need only go back to the last time it emerged, in August
of 1995. Prior to this date, many Japanese banks were already facing financial
difficulty. A number of them had had large losses in their equity holdings
in Japanese firms associated with the collapse of Japan's stock market
in 1990 and 1991. Many also were exposed to capital losses in Japanese
real estate, particularly through Japanese bank subsidiaries, known as
jusen companies. These difficulties faced by Japanese banks were
well understood by the market. For example, Cargill, et al. (1997) report
that concerns about the solvency of the jusen companies were raised
as early as 1992. Despite these difficulties, however, and the heterogeneity
they implied in failure risks, all Japanese banks faced virtually no premium
in borrowing costs.
The event leading to the emergence of the Japan premium was the announced
failure of Hyogo Bank in August of 1995. Hyogo Bank was the first commercial
bank failure in Japan. It was the 38th largest bank, with $37
billion in assets (Peek and Rosengren 2000). Prior to this date, Japanese
authorities had intervened to preclude failure by any commercial bank,
arranging the merger of an insolvent bank with a solvent acquiring bank.
In return for its acquisition of the insolvent bank, the acquiring bank
received its branching rights, which were quite valuable in some Japanese
cities. It has also been speculated that the acquiring bank enjoyed preferential
regulatory treatment in return for taking the insolvent bank onto its
books (e.g., Hoshi 2000).
Peek and Rosengren show that after the fall of 1995, the Japan premium
went as high as 0.5%, and then fell to approximately 0.1% for 1996 and
much of 1997. In November of 1997, however, the Japanese economy suffered
a rash of failures, including two major securities firms, Sanyo and Yamaichi,
and the first failure by a Japanese "city bank," Hokkaido Takushoku.
In that month the premium spiked up to 0.8% for Bank of Tokyo-Mitsubishi
and 0.9% for Fuji Bank.
Peek and Rosengren demonstrate that changes in the degree of regulatory
protection afforded to banks influenced the Japan premium's magnitude
in the 1990s. For example, it was the change in the market's perception
of the willingness of Japanese authorities to allow insolvent banks to
fail that caused the premium to emerge after the failure of Hyogo Bank.
Foreign holders of subordinated debt were asked to write off part of their
claims, revealing that foreign creditors of Japanese banks were now exposed
to failure risk.
Policy changes also can influence the Japan premium by changing the
expected burden borne by commercial banks in the resolution of financial
difficulties in the nation. For example, Cargill, et al. (1997) note that
the August 1995 date also coincides with the Ministry of Finance's proposed
"all Japan" resolution of the problem jusen loans. This
policy required unrelated banks to contribute to the resolution of bad
jusen loans and caused concern about commercial banks' future burdens
in resolving failures by other banks.
Similarly, Spiegel and Yamori (2000) find that a portfolio of strong
large bank equities lost more value on the date of the Hyogo Bank failure
than a portfolio of weak large banks. They conclude that the discrepancy
was attributable to the net contributions called upon from large banks
to assist in the resolution of Hyogo. Financially strong banks are more
able to assist failing banks without experiencing difficulties themselves
and, hence, were called upon with greater frequency to participate in
an assistance package. Consequently, news that banks are being called
upon to share in the resolution of failed banks is relatively worse news
for strong banks than weak banks.
The 2001 return of the Japan premium
Unlike the Hyogo Bank failure that appeared to trigger the initial emergence
of the Japan premium in 1995, it is difficult to identify a single major
event as the cause of its return in mid-January 2001. However, two developments
in January could have raised investors' concerns about the default risk
in offshore Japanese bank loans.
First, the stock market began the month by continuing to fall, nearing
its October 1998 post-bubble low. As Japanese banks are major holders
of Japanese equities, these market declines directly deteriorate their
balance sheet positions, although many of these losses are currently unrealized.
This has led to speculation by prominent banking analysts that additional
government support would be needed beyond the roughly 15 trillion yen
emergency fund that will be set aside for problem banks. (Note, however,
that the government suggested that additional support probably would not
be needed. Financial Services Agency Commissioner Mori noted that Japanese
banks held relatively small shares of the information technology stocks
that had accounted for much of the stock market's precipitous decline.)
Second, there was additional adverse news about the condition of
Japanese banks. On January 11, the Nihon Keizai Shimbun reported
that the government's cost of financing the resolution of five "second
regional banks" that failed in 1999 would be higher than previously
anticipated. "Second regional" banks are smaller than city banks,
but still sizable—for example, the cost of restructuring one of the five
failed banks, Namihaya, was estimated to be close to $8 billion. The continuation
of difficulties in the resolution of these failed banks may be perceived
by investors as having adverse implications for the regulatory protection
of unsecured debt against future bank failures. In addition, it may also
lead investors to believe that the balance sheets of solvent banks are
more troubled than they had previously believed.
This combination of continued adverse economic news and uncertainty
concerning the possibility of a government bailout in the event of bad
outcomes appears to have resulted in the return of the Japan premium.
Conclusion
At 0.05% or 0.07%, the current Japan premium is roughly equivalent to
its level in 1996. It is less than a tenth the size of the premium faced
by Japanese banks in November of 1997. At these levels, as Japanese officials
have stressed, it is unlikely to be a material hindrance to the borrowing
capabilities of Japanese banks.
To the extent that the premium reflects expectations about the future
repayment prospects on Japanese debt, it may signal investors' expectations
about future Japanese bank performance. However, the size of the premium
also may be greatly influenced by government policy. As such, the premium
is an imperfect indicator of the expected future difficulties faced by
the Japanese financial system.
For example, a small premium could have two sources: First, investors
could believe there is a small probability of insolvency by the borrowing
bank, but then believe that their loans will not be serviced if the bank
defaults. Alternatively, investors could perceive that the probability
of bank insolvency is quite high, but then perceive that the government
would intervene in the event of default in a manner that would leave their
claims on borrowing banks close to whole.
These two polar cases imply that the same magnitude Japan premium
could portend very different scenarios for the future stability of Japan's
financial system. Under the first, the financial system is expected to
be in relatively stable condition. Under the second, investors expect
a great amount of turbulence. As such, one should probably neither have
great concern about the return of the Japan premium nor take great solace
in the fact that it is currently small.
Mark Spiegel
Research Advisor
References
Cargill, Thomas F., Michael M. Hutchison, and Takatoshi Ito. 1997.
The Political Economy of Japanese Monetary Policy. Cambridge,
MA: MIT Press.
Hoshi, Takeo. 2000. "Convoy System." Mimeo. University of California,
San Diego.
Peek, Joe, and Eric S. Rosengren. 2000. "Determinants of the Japan
Premium: Actions Speak Louder than Words." Journal of International
Economics 53, pp. 283-305.
Spiegel, Mark M., and Nobuyoshi Yamori. 2000. "The
Evolution of Too-Big-To-Fail Policy in Japan: Evidence from Equity Values."
FRBSF Center for Pacific Basin Studies Working Paper 00-01.
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