FRBSF Economic Letter
2001-06 | March 9, 2001
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.
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.
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.
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.
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.
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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