FRBSF Economic Letter
2002-38; December 27, 2002
Financial Issues in the Pacific Basin Region: Conference Summary
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.
This Economic Letter summarizes the papers presented at the
conference "Financial Issues in the Pacific Basin Region" held
at the Federal Reserve Bank of San Francisco on September 26-27, 2002,
under the joint sponsorship of the Bank's Center for Pacific Basin Monetary
and Economic Studies and the Journal of the Japanese and International
Economies. The papers are listed at the end and are available at http://www.frbsf.org/economics/conferences/0209/index.html.
The six conference papers examine important financial issues of relevance
to the Pacific Basin. Four papers focus on Japan's banking sector problems.
Two others focus on exchange rate policies in the Pacific Basin region.
Japanese banking reform
The persistent weakness of the Japanese banking system has been confounding
that country's policymakers since the early 1990s, despite passing several
programs to improve the situation. Among the most notable programs are
two that were enacted in 1998. One is the Financial Reconstruction Act
(FRA), which established a framework for dealing with failed Japanese
banks; the other is the Rapid Revitalization Act (RRA), which allowed
for the injection of public funds to solvent Japanese banks needing assistance
to deal with their bad loans and clean up their balance sheets.
Mark Spiegel (FRBSF) and Nobuyoshi Yamori (Nagoya University, Japan)
conducted an event study, analyzing how the news about the passage of
these programs affected the equity values of Japanese banks. Their conjecture
is the following: if market participants expected the passage of these
laws to improve bank regulatory control in Japan, then equity values should
fall for banks that are financially weak or poorly regulated.
Their results suggest that, while there was some perception that the
FRA would lead to adverse treatment of weaker regional banks, the market
expressed a healthy skepticism that the overall regulatory changes of
1998 would lead to serious reform. This implies that the actual closures
resulting from the FRA were expected to be limited largely to regional
banks. In addition, they find that news concerning the passage of the
RRA was treated as disproportionately beneficial to the weaker regional
and large city banks in the Japanese financial system; that is, the market
anticipated that the government's capital injections would simply allow
these banks to postpone or avoid financial reforms, rather than induce
them to clean up their balance sheets. The performance of Japan's banking
system since the passage of the FRA and the RRA lends some credence to
the notion that the markets were skeptical about the pace of reform afforded
by these regulatory changes.
Loans to Japanese borrowers
David Smith (Federal Reserve System Board of Governors) conducts an empirical
analysis of the Japanese banking system by assembling and analyzing data
on loans to large Japanese firms. He tests the hypothesis that Japanese
banks have been unprofitable over the past decade because they have been
pricing their loans below profitable levels.
Smith's data show that the interest rate premiums on loans to Japanese
firms were lower on average than those to borrowers from other developed
countries. The lower premiums could reflect the underpricing of risks
by Japanese banks due to one or more factors, including implicit government
guarantees, strong relationship commitments to the borrower, and a desire
to keep loans "performing" so as not to have to hold reserves
against loan losses. However, the Japanese loans also were characterized
by higher credit ratings, larger loan amounts, and—at least until 1997—longer
maturities, all suggesting that they were less risky. This implies that
they may have been priced appropriately. Indeed, after controlling for
the characteristics related to loan riskiness in a regression analysis,
the interest rate premium differences on loans from Japanese and non-Japanese
banks disappears. Nevertheless, some question remains about how well these
findings reflect typical loans to Japanese businesses.
Bank regulation and financial crises in Japan
Robert Dekle (University of Southern California) and Kenneth Kletzer
(University of California at Santa Cruz) develop a formal banking sector
model as a framework for understanding Japan's recent experience. In their
model, government deposit insurance guarantees create moral hazard that
encourages banks to underprice the true riskiness of their loans and to
make riskier loans. Consequently, if adverse shocks hit the economy, depressing
the value of the collateral underlying loans and leading some borrowers
to fail, banks still will make more loans, even as the share of nonperforming
loans in their portfolios rises. Eventually, the health of the banking
sector deteriorates to the point that banks themselves become insolvent,
bank loans dry up, and aggregate output declines.
The authors note that the dynamics of their model fit Japanese experience.
As Japan was hit by a succession of adverse aggregate shocks in the 1990s,
bank portfolios continued to deteriorate, and the market value of collateral
(in particular, land) collapsed. The decline in collateral values in turn
led to a fall in bank lending, a decline in physical investment, and finally,
a fall in output.
Bank failures and banking relationships in
Japan
A question of great interest to policymakers is how bank failures affect
banking relationships, as reflected by the impact on the failing bank's
customers. A bank failure interrupts the flow of credit to its customers,
forcing them to find alternative financing. The extent to which these
customers will be affected depends on such characteristics as their dependency
on bank financing, their financial condition, and the industry to which
they belong. If an individual bank failure is significant enough and signals
the poor state of the financial sector or of the economy, it may adversely
affect firms that are not only its own customers but also customers of
other banks.
To shed light on these effects, Elijah Brewer III, Hesna Genay, William
Curt Hunter (all from FRB Chicago), and George G. Kaufman (Loyola University)
examine the stock prices of over 1,000 Japanese firms following the 1997
failure announcement of the Hokkaido Takushoku Bank and the 1998 failure
announcements of the Long-Term Credit Bank of Japan and the Nippon Credit
Bank. In line with previous research for the U.S., they find that the
customers of a failed bank experience negative abnormal returns around
the time of the failure announcement; the extent of this effect is related
to the firm's financial characteristics. Firms with greater access to
alternative sources of funding are less adversely affected by bank failure
announcements. The authors also find that the adverse impact of a failure
on the market value of firms that are its customers is not significantly
different from the impact on firms that are not its customers. That is,
bank failures are "bad news" for all firms in the economy, not
just for the customers of the failed banks.
To the extent that these results for Japan are representative, they cast
doubt on the importance of bank failures to bank customer relationships.
They also raise questions about the meaningfulness of other studies' results
finding significant adverse effects of a bank failure on its loan clients
if those studies do not also test for the effect on firms other than the
failing bank's clients.
High demand for international reserves in
Asia
In the aftermath of the Asian financial crises of 1997-1998, many countries
in the region purportedly moved to exchange rate regimes with greater
flexibility. In theory, there should be less demand for foreign exchange
reserves under flexibility. In fact, however, most Asian countries have
accumulated substantial reserves in recent years.
Joshua Aizenman (University of California at Santa Cruz) and Nancy Marion
(Dartmouth) analyze developing countries' demand for foreign exchange
reserves, with special emphasis on understanding the reasons for the big
accumulation of foreign reserves by Asian countries. Using panel data
for 125 developing countries over the period 1980-1996, they show that
reserve holdings can be predicted well by several key variables, including
country population, GDP per capita, the volatility of international transactions,
and political factors. The estimating equation also does a good job of
predicting reserve holdings of East Asia countries before the 1997 financial
crisis, but underpredicts their holdings after the crisis; that is, their
reserve levels in recent years are higher than the estimated model can
explain.
To explain this finding, they formulate several models that are consistent
with this underprediction result. Specifically, one model shows that if
raising taxes is costly and access to global credit is limited in times
of crisis, then countries will choose to hold foreign reserves for precautionary
reasons. This precautionary demand rises with higher perceived sovereign
risk and higher fiscal liabilities (both explicit and implicit)—such
as may occur in the aftermath of a crisis. This precautionary demand declines
if policymakers are impatient (that is, if the discount rate is high)
or political arrangements are unstable or corrupt. A second model shows
that the demand for reserves is higher if policymakers are loss-averse,
that is, they attach more weight to bad outcomes than to good ones. Hence,
if a crisis increases the loss-aversion or the volatility of shocks, it
also will increase the demand for reserves. The implication is that an
econometric specification incorporating some of these factors would do
better in explaining the observed high reserve holdings of Asia countries
since 1997.
Post-crisis exchange rate policy in Asia
Leonardo Hernández (Central
Bank of Chile) and Peter Montiel (Williams College) ask three questions
about the exchange rate policies of Asian countries: (1) Are Asian countries
managing their exchange rates more or less now than before the 1997-1998
crisis? (2) If they're managing their exchange rate, why are they doing
it? (3) Does the specific experience of these Asian countries provide
general lessons for other emerging markets?
The paper answers the first question by inspecting some simple statistical
measures of the relative variability of exchange rates, foreign reserves,
and domestic interest rates for the five Asian countries most affected
by the crisis of 1997-1998—Korea, Thailand, Indonesia, Philippines, and
Malaysia. They conclude that these countries manage their exchange rates
less in the post-crisis period than before, but do so more than "purer"
floaters, such as Germany/Euroland and Japan. (Malaysia, because of its
capital controls, has been able to maintain a fixed exchange rate and
is the outlier in the sample.) These results are consistent with those
who argue that developing countries have a "fear of floating."
The authors attribute the continued intervention activity by Asian policymakers
to a desire to limit the adverse competitive effects of appreciations
as well as to a desire to accumulate reserves. Lastly, on the basis of
the Asian experience, they argue that active management of the exchange
rate is still feasible, even when countries maintain open capital markets.
Thus, developing countries need not choose solely between adopting a hard
peg or allowing full exchange rate flexibility.
Reuven Glick
Vice President, International Research, and
Director, Center for Pacific Basin Monetary and Economic Studies
References
Aizenman, Joshua, and Nancy P. Marion. "The
High Demand for International Reserves in the Far East: What's Going On?"
Brewer, Elijah III, Hesna Genay, William C.
Hunter, and George G. Kaufman. "The Value of Banking Relationships
during a Financial Crisis: Evidence from Failures of Japanese Banks."
Dekle, Robert, and Kenneth M. Kletzer. "Financial
Intermediation, Agency and Collateral and the Dynamics of Banking Crises:
Theory and Evidence for the Japanese Banking Crisis."
Hernández, Leonardo, and Peter J. Montiel.
"Post-Crisis Exchange Rate Policy in Five Asian Countries: Filling
In the 'Hollow Middle'?"
Smith, David C. "Loans to Japanese Borrowers."
Mark M. Spiegel and Nobuyoshi Yamori. "The
Impact of Japan's Financial Stabilization Laws on Bank Equity Values."
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