Recent developments in Japan's financial sector: Bad loans and financial deregulation

SYMPOSIUM

Recent Developments

in Japan’s Financial

Sector: Bad Loans and Financial Deregulation MITSURU TANIUCHI

This paper discusses two major recent developments in Japan’s financial sector. First, the bad loans problem is reviewed to assess to what extent bad loans have affected banks and to identify issues that need to be addressed. Japanese banks have been experiencing balance sheet troubles to an extent unseen in the post-World War II period. Second, financial deregulation is reviewed and its future direction is discussed. Impo~~t deregulation measures have been introduced, albeit at a cautious pace, to Japan’s financial sector which until recently was heavily regulated and protected. In an effort to address such concerns as the lack of international competitiveness and the hollowing-out of the sector, Prime Minister Hashimoto has recently pledged to introduce Japan’s equivalent of Britain’s “Big Bang” by the year 200 1. The resolution of bad loans and the introduction of extensive deregulation would most likely lead to a major reorganization of Japan’s financial sector, entailing the closure of some weaker institutions.

I.

INTRODUCTION

Japan’s financial sector has been undergoing significant changes in recent years. Important deregulation measures have been introduced, albeit at a cautious pace, to the financial sector which until recently was quite heavily regulated and protected. Controls on interest rates had been gradually deregulated from 1979, and was finally completed in 1994. Japan’s financial sector has Long been comp~mentalized because of stiff regulations to separate the functions that different types of financial institu_ Mitsuru Taniuchi * Chief Economist. the Economic Research Institute of the Economic Planning Agency, Government of Japan. Journal of Asian Fkmmmics, Vol. 8, No. 2. 1997 pp. 215-244 ISSN: 1049-0078

Copyright 0 1997 by JAI Press Inc. All rights of reproduction in any form reserved.

225

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tions can perform. In 1994, major changes were introduced to this long-standing policy of the separation of functions. Yet important restrictions on activities of financial institutions remain. Some economists as well as journalists have voiced concerns about the lack of international competitiveness of Japan’s financial sector and the “hollowing out” of the sector. In an effort to address such concerns, in November 1996, Mr. Hashimoto announced his intention to introduce Japan’s equivalent of Great Britain’s “Big Bang” by the year 2001.’ At the same time as extensive deregulation measures are to be introduced to make Japan’s financial sector more efficient and innovative, its banking sector is strapped with huge amounts of bad loans. During the “bubble boom” in the late 1980s banks actively lent to real estate developers, either directly or indirectly through their nonbank affiliates. The end of the bubble boom, particularly the collapse of land prices at the beginning of the 1990s has turned much of such lending sour. Many Japanese banks are now saddled with large amounts of bad loans. The bad loans problem coupled with the intensifying competitive situation due to financial deregulation has generated concerns about future bank earnings and the possibility of some weaker banks being forced to close. Recurring bouts of jitters in financial markets about the stability of the banking sector have led not only to higher costs for Japanese banks to procure funds from overseas in international interbank markets (the “Japan premium”), but even to a major sell-off of bank shares in the Tokyo stock market at the beginning of 1997. This paper discusses the aforementioned two major developments in Japan’s financial sector in recent years. First, the bad loans problem, which has been hobbling Japan’s banking sector, is reviewed to assess to what extent bad loans have affected banks and to identify the issues that still need to be addressed. Second, financial deregulation to date is reviewed and the directions it must be taking are discussed. The transformation of Japan’s financial sector into a more competitive one makes it necessary to both resolve banks’ balance sheet troubles and eliminate remaining regulations. This process will most likely lead to a major reorganization of the financial sector, entailing the closure of some weaker institutions.

II. A.

THE BAD LOANS PROBLEM

Assessment of Banks’ Balance Sheet ‘I?oubles

The balance sheets of Japanese banks (including all depository institutions) have been deteriorating to an extent unseen in the post-World War II period. The recent bad loans problem arose from the sharp decline in land prices after the end of the bubble boom and the prolonged weak conditions of the Japanese economy in the several years thereafter. During the bubble boom in the late 1980s banks actively extended loans either directly to property developers taking high-priced lands as collateral, or indirectly via

227

~e~e~~p~ents in Japan’s Financial Sector

non-bank finance companies like the now-liquidated housing loan companies, which on-lent to property developers. In fact, bank lending to both the real estate industry and non-banks rose from 19% of total lending in 1985 to 27% in 1989. With the sharp decline in land prices from 1992, much of these loans as well as other loans made under lax credit standards during the boom have gone sour.

Bad Loans of Large Banks. For the 21 major banks (20 banks from April 1996 because two banks merged), non-performing loans were estimated to total 8.0 trillion yen, or 2.2% of total loans in March 1992, and they ballooned to 12.8 trillion yen, or 3.5% of total loans one year later (see Table 1). The major banks include 11 city banks (10 from March 1996), 3 long-term credit banks, and 7 trust banks (trust and banking companies).2 It should be noted that the term “non-performing loans” applied before March 1996 includes loans to legally bankrupt companies and loans that are at least six months overdue, but does not include restructured loans that have been partially or entirely relieved of interest payments. From March 1996, the major banks started to disclose the amount of restructured loans as well. The amount of non-performing loans not including restructured loans has been steady since 1993 in terms of both the yen amount and their share in total loans. The steadiness of non-pe~o~ng loans despite write-offs and sales of bad loans means that some portion of loan portfolios has continued to become delinquent each year. It should be noted, however, that when restructured loans disclosed since March 1996 TABLE 1.

Financial Indicator of the Major Banks (1) (From Balance Sheets) (trillion

yen)

March

March

March

March

March

Sept

1992

1993

1994

1995

1996

1996

Total ------ loans -----Bad loans (l)=a+b+c

362.52 ----na

362.98

353.56

366.08

386.80

na

21.83

17.41

(% of total loans)

na 8.00

Bad loans (2)=a+b (% of total loans) Loans to bankrupt companies Overdue Loans (b) Restructured Loans (c) Loan loss revenues Coverage for bad loans (1) (%) ~_____~___.______

(2.2%) (a)

na na

na

na

(6.0%)

(4.5%)

12.77

13.57

12.54

13.08

13.14

(3.5%)

(3.8%)

(3.5%)

(3.6%)

(3.4%)

na

1.95

2.29

2.63

3.03

2.97

9.92

10.04

10.17

8.75

4.27

na

10.82

11.28

na

na

na

na

2.96

3.70

4.55

5.53

na

na

na

na

17.27 17.79 Unrealized capital gains on securities Source: Federation of Bankers Association of Japan, Arm&is ofFinancial Ministry of Finance. Bad Loans Situai~o~s o~D~~~iIo~ OECD, Economic Surveys Japan 199-96. Note:

357.28 ----------_na

20.39 Stcztetnents

i~s?;~uti~~~,

10.34

8.24

(47.4%)

(47.3%)

16.52

16.11

9.01 ofAll

Banks, various

issues.

September 1996.

Data of September 1996 are from the Ministry of Finance, and the figure of bad loans in March 1992 is from OECD. All other data are from Federation of Bankers Associations.

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were included, non-performing loans totaled 17.4 trillion yen (4.5% of total loans) in September 1996, down from 21.8 trillion yen (6.0%) in March 1996. During the year to March 1996, the major banks significantly increased loan loss reserves, reducing their exposure to bad loans by as much as 4.9 trillion yen during the year (see Table 2.) As a result, the major banks recorded unprecedented operating losses, even though their net core profits substantially increased due largely to large increases in profit from dealing of government bonds, and also capital gains on equity portfolios which are added to net core profits in obtaining operating profits (losses) were substanti~. “Net core profit (loss)” is the amount by which normal operating revenues exceed (fall short of) normal operating expenses. Note here that “normal revenues” do not include (realized) capital gains on equity portfolios, and “normal expenses” do not include bad loan charges. 3 “Operating profit (loss)” is obtained after bad loan charges and other expenses are deducted and capital gains on equity portfolios are added. Given the recent levels of net core profits (the three-year average to March 1996 is taken here), the major banks could fully cover their exposure to the outstanding total of non-performing loans (including restructured loans) as of March 1996 in about three years, without further reducing their capital base. But full provisioning will not be necessary, because some portion of bad loans can be recovered once the collateral has been sold. The residual value of the existing bad loans is unknown, and depends, among other things, on future land prices. One bid of useful information in deducing the residual value is the fact that the Cooperative Credit Purchasing Company (CCPC) that was established in 1993 by banks to buy up their bad loans had purchased bank loans at an average discount of 59.5% since its inception to September 1996.4 (Issues concerning the CCPC will be discussed later.) If in fact the residual value of the outstanding bad loans is about 40% of the book value, the major banks could fully cover their exposure to bad loans by adding provisions that equal about two-years’ net core profits.

TABLE 2.

Financial Indicators of the Major Banks (2) (From Income Statements) (trillion yen) 1991.4/92.3

1992.4/93.3

Operating profit

1.97

1.31

0.80

0.21

-3.28

Net core profit ___.-_-_----_------Bad loan charges (a+b+c)

2.43

3.22

2.77

4.77

0.56

1.35

3.15 __-___3.15

3.55

8.42

Write-offs (a)

0.05

0.20

0.23

0.70

1.64

Loan loss provisions (b)

0.51

0.94

1.14

1.40

5.57

Loss on loan sales to CCPC (c)

0.00

0.21

1.77

1.44

1.21

na

na

na

na

2.19

0.80

0.03

1.80

3.07

Loss on assistance to affiliates ___..-__-------~~--~~~-~~~ Capital gains of securities (net) Source: Federation of Bankers Association

of Japan, Annlysis ofFinancial

1993.4/94.3

1994.4/95.3

-.Statements

ofAIl

Banks,

various issues.

199X4/96.3

----

3.14

Developments

in Japan’s Financial Sector

229

The above calculations suggest that the bad loans problem is now a manageable one as long as the major banks are concerned. But, a few caveats are in order. First, putting all the major banks together in the same boat is somewhat misleading, because the extent of balance sheet troubles differs very much from bank to bank. In particular, a few of the major banks still have high levels of bad loans in relation to their loan portfolios and yet their loan loss reserves are not quite sufficient to cover their exposure to bad loans (see Table 3). Second, as discussed earlier, new additions to bad loans appear to be continuing, although the total amount of bad loans has not been expanding owing to write-offs and loan-sales. Third, there are lingering doubts about the veracity of bank disclosure of bad loans. For example, the recently-failed regional banks revealed that the amounts of their bad loans were in fact the multiple of the previous disclosure. The major banks have recently started disclosing the amounts of restructured loans, and regional banks have also improved disclosure of their bad loans recently as will be mentioned later. This was an important step to dispel doubts in the financial markets. There is a possibility, however, that banks are still concealing bad loans by providing new loans to potentially delinquent borrowers for their debt-servicing. Bad Loans of Regional Banks and Other Depository Institutions. The disclosure of bad loans of regional banks (which consist of first- and second-tier regional banks and total about 130 banks) was fragmentary until recently. Before March 1996, regional banks had reported only the amounts of loans to bankrupt companies, but they have since disclosed overdue loans and restructured loans as well. Generally speaking, second-tier regional banks, which were formerly mutual savings associations, are harder hit by bad loans than first-tier regional banks which have stronger local franchises. In September 1996, non-performing loans (including restructured loans) of second-tire regional banks account for 4.2% of total loans, whereas those of first-tier banks account for only 2.5%. In addition, the second-tier banks are more exposed to bad loans with their insufficient loan loss reserves than the first-tier banks. In fact, all of the four regional banks that have gone bankrupt in recent years (Toho-Sogo, Taiheiyo, Hyogo, and Hanwa) were second-tier banks. Cooperative-type financial institutions, which take deposits and extend loans, include Shinkin banks, credit cooperatives, and agriculture cooperatives, and are run as mutual institutions. They disclose little information on bad loans. The Ministry of Finance has recently started to disclose aggregate information on bad loans of cooperative-type financial institutions as a whole (from September 1995), and on bad loans of three major groups of Shinkin banks and credit cooperatives (from March 1996), and agricultural cooperatives (from September 1996). Most of these institutions do not disclose bad loans individually. (See Table 3). Among cooperative-type financial institutions, credit cooperatives are particularly vulnerable, having large amounts of poor-quality loans in their portfolios. In September 1996, the average ratio of non-performing loans (including restructured

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TABLE 3.

OF ASIAN ECONOMICS

8(Z), 1997

Bad Loans of All Depository Institutions (%) Coverage by Lnss Reserve

Bad Loans ffotat Loans

Grmp of3anks Major Banks (20)

39.8

4.5 (Higher than 10%)

Nippon Credit Bank

13.9

25.0 34.3

Hokkaido Takushoku Bank

13.3

Yasuda Trust & Banking

10.9

33.2

Mitsui Trust & Banking

10.2

38.3

(Lowest) Tokyo Mitsubishi Bank

45.4

2.8

Sanwa Bank ________--_------~-First-Tier Regional Banks (64)

2.5

----_--

42.8 37.0

2.5 (Highest)

Asikaga Bank Ryukyu Bank

8.0

39.3

7.7

17.4

(Lowest) Toyama Bank -__----_----___.._-_--Second-Tier Regional Banks (65)

0.2

-------

53.5 28.9

4.2 (Higher than 10%)

Midori Bank

15.0

3.9

Tokuyo City Bank

11.6

21.5

Kyoto Kyoei Bank

10.8

22.9

Kokumin Bank

10.6

24.1

(Lowest) Tokushima Bank __---_-----Cooperative-type Institutions

---------

Shinkin Banks (412) Credit Cooperatives

(368)

Agricultural Cooperatives __-------All Depository Institutions Source: Noret

(2264)

__--_----

123.3

0.4 4.8

18.1

4.8

24.5

12.3

5.7

1.0 _

-

_---_--

4.2

25.0 34.0

Ministry of Finance, Bad Loans ofDepository Insrikms September, 1996 Kinyu Business March, 1997 issue. I. Specific loan loss reserves are taken for loan loss reserve. 2. Data on bank groups are from Ministry of Finance. Data on individual banks are from Kinyu Business. 3. The numbers in parentheses are those of banks and institutions as of September 19%. 4. Midori Bank is a new bank established in January 1996 that took over the defunct Hyogo Bank.

loans) to total loans was as high as 12.3%, and only 5.7% of non-performing loans were covered by loan loss reserves. Eight failed credit cooperatives have already either merged with healthier insti~tions or been liquidated in the 1990s. (In addition, two Shinkin banks have failed to date.) In the well-publicized case of the failures of

Developments

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231

two credit cooperatives in Tokyo (Tokyo Kyowa and Anzen) in 1994, their bad loans amounted to as much as 82% of their loan portfolios. Agricultural cooperatives had been the biggest lender as a group to the now-liquidated seven housing loan companies, providing nearly half of their total funding. Their exposure to loans to the housing loan companies (13.3% of their total loans in 1995) was the highest among all categories of financial institutions. However, in the housing loans resolution scheme introduced in June 1996 (which will be discussed in detail below), agricultural cooperatives were fully paid back their loans totaling some 5.5 trillion yen, and agreed to contribute only 530 million yen to pay for the loss. As a result, as of September 1996, non-performing loans of agricultural cooperatives accounted for only 1.O% of their total loans. B. Some Issues on How Banks Have Handled Bad Loans The foregoing reviews indicate that some weaker banks and cooperative-type financial institutions continue to have serious balance sheet troubles, but that the banking sector is not susceptible to systemic risks due to the bad loans problem. And most of the major banks have managed to reduce their exposure to bad loans to a manageable level. However, the way in which the major banks have addressed bad loans to date has not led to a real resolution of the problem. In other words, the bad loans problem is likely to remain a factor in reducing bank profits. Incidentally, in early 1997, there was a major sell-off of bank shares in the Tokyo stock market, stemming from concerns about future bank earnings that could be squeezed by bad loans and increasing competition arising from the planned “Big Bang.” The following issues regarding banks’ handling of bad loans are worth noting. These issues concern mainly the major banks, but some of them are relevant to regional banks as well. Loan Loss Provisions vs Write-offs. The major banks have significantly increased bad loan charges in the past several years (from 0.6 trillion yen in the year to March 1992 to 8.4 trillion yen in the year to March 1996). Most of these charges have been loan loss provisions and losses on loan sales to the Cooperative Credit Purchasing Company (CCPC). As will be discussed later, the latter are, in effect, tax-free provisioning of bad loans. On the other hand, write-offs have been limited. It should be noted that, in the year to March 1996, the major banks charged large “losses on assistance to affiliate companies,” and that the amount of such losses had not been disclosed prior to that year. Those losses are mostly writeoffs and provision of grant to the banks’ affiliate companies such as lease companies and credit-guarantee companies. By accumulating adequate loan loss reserves, banks could avoid falling into operating losses in the future when loan losses materialize. Unless bad loans are replaced by performing assets, however, bank earnings would continue to be adversely affected by bad loans. From this viewpoint, it would be necessary for banks to fore-

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close the collateral and write off losses right away. But the prolonged decline in land prices has discouraged banks from selling collateralized properties. Banks appear to have been waiting the economy and particularly the real estate market to rebound, hoping that overdue borrowers could begin to service their debts or that banks could sell off collateralized properties. Unfortunately, such an optimistic scenario has not, as yet, materialized. It appears necessary to introduce some creative methods to get around the present difficult situation. One such method is to pool property collateral, commission a property management company to manage or sell off those properties, and securitize the cash flow from them. This would enable banks to recover the residual value of bad loans. In the US, the Resolution Trust Corporation that took over failed savings and loan associations (S&Ls) successfully securitized commercial mortgages of bad loans in the early 199Os, and some major commercial banks followed suit. But, in Japan, there has as yet been only a limited cases of securitization of bad loans, because of complicated entanglement of legal rights such as multi-layer mortgages and protected tenant rights in addition to the general lack of experience in this type of securitization. Loan Sales to the Cooperative Credit Purchasing Company (CCPC). The major banks have charged large losses on loan sales to the CCPC during the recent several years. The CCPC was established in 1993 with the objective of allowing banks to make tax-free bad loan charges. Since its inception to September 1996, the CCPC had purchased bad loans worth 12.9 trillion yen at book value, at an average discount of 59.5%. The CCPC’s purchase of a bad loan is financed by the loan-selling bank which makes a loan to the CCPC. Once the real estate collateral of the bad loan is sold, the CCPC will repay the loan-selling bank for the principal and accrued interests of the bank loan extended to the CCPC. If the collateral is sold at a price lower than the purchasing price of the bad loan plus accrued interests, the loan-selling bank must bear the loss. With this arrangement, the bank can make a tax-free charge for the loss on loan sales to the CCPC without a long wait for the sell-off of the collateral. However, it is worth noting that this transaction simply replaces the residual value of a bad loan with another loan to the CCPC which pays no interest until the CCPC succeeds in selling the collateral. In short, a bad loan is replaced by just another “non-performing” loan. In fact, the CCPC has managed to sell only 4.7% of its portfolios since inception, because of continuing weak conditions in the real estate market. Thus, the CCPC scheme, in effect, provides banks with a means to make taxfree loan loss provisions, but it does not actually relieve banks of bad loans. In addition, this scheme is not very helpful for weaker banks, because their net core profits are low and they have little cushion of unrealized gains on equity portfolios, so that they do not have much resources to deduct the losses on loan sales to the CCPC. Unrealized Capital Gains as a Source of Bad Loan Charges. The major banks rely heavily on unrealized capital gains on their equity portfolios to make bad loan charges. For the recent three-year period to March 1996, the major banks used unre-

Developments

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233

alized capital gains to finance 53% of their bad loan charges for the same period (see Table 2). Most banks have sold company shares in their portfolios to realize capital gains, but in many cases they have immediately bought those shares back in order to maintain cross-shareholdings among group companies. With such transactions, the book values of company shares in their portfolios have increased so that earnings per share at book value have lowered. In short, bad loans have been replaced by poorlyperforming equity portfolios. While this accounting gimmick does not alter the earning power of banks, it has some important ramification for banks’ financial management. Japanese banks are permitted to count 45% of unrealized capital gains on their equity portfolios as part of their supplementary capital (tier-two capital) to meet the BIS requirements. When banks use the cushion of unrealized gains to make bad loan charges, the weakening of the stock market would force banks to find other financing sources to meet the BIS requirements. Since the issuance of subordinate debts or preferred stocks would cost banks more to meet the BIS requirements, bank earnings would be adversely affected. Furthermore, banks which markets perceive are experiencing difficulties in meeting the BIS requirements would face higher funding costs in international interbank markets. Banks’ reliance on unrealized gains for making bad loan charges and for meeting the BIS requirements has some risks. In January 1997, the Nikkei Average of the Tokyo Stock Exchange stumbled to a two-year low of close to 17,000 yen. According to an estimate by the Nikko Research Center (January 1997), the level of the Nikkei Average that would wipe out unrealized gains for the 20 major banks ranges from 18,000 to 13,000 yen. Resolution of the Housing Loan Fiasco. A symbolic case of the bad loans problem of the banking sector has been the housing loans companies (“jusen”) problem. Seven housing loans companies were established in the 1970s by the major banks and regional banks. However, since the 1980s banks have become more active in providing housing loans themselves, threatening the original franchise of the housing loans companies. Furthermore, the real estate market experienced a frenzy boom in the late 1980s so that all housing loans companies expanded lending to property developers under lax and often questionable credit standards. With the decline in land prices and the onset of a severe recession at the beginning of the 1990s most of their loans became non-performing, and the market values of real estate collateral fell sharply. In 1995, 74% of their loans were non-performing. Since the housing loans companies borrowed heavily from banks and agricultural cooperatives, their dire difficulties affected those financial institutions directly. After a government-sanctioned package for loan restructuring agreed upon in 1993 by all lender institutions had proved impractical, the government finally put together a more comprehensive resolution scheme with the injection of public money. In June 1996, the Diet passed the legislation necessary for this resolution scheme.

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Under the new scheme, all of the housing loans companies were liquidated, and the newly-established Housing Loan Administration Corporation (HLAC), which will be wound up in 15years’ time, took over their assets and liabilities. The banks that had founded the housing loans companies (founder banks or “mother banks”) abdicated and wrote off all of their loans worth 3.5 trillion yen and equities. Nonfounder banks also abdicated 1.7 trillion yen, 44% of their loans. Agricultural cooperatives, which as a group had been the biggest lender to the housing loans companies, were fully paid back due largely to their political clout, but they agreed to pay 0.53 trillion yen as a grant to the HLAC. All these lender institutions provided some 6.5 trillion yen of below-market-rate lending to the HLAC for its purchase of the loan assets of the housing loans companies. The government granted 0.68 trillion yen to the HLAC. The above arrangement addresses only part of the losses of the housing loans companies, referred to as the “first-round losses.” The HLAC is not expected to fully recover its inherited loans. It has been agreed, in the resolution scheme, that the losses that remain when the HLAC closes, referred to as the “second-round losses,” are to be shouldered evenly by the lender institutions and the government. Although the amount of the second-round losses depends on, among other things, future land prices, it is likely to be substantial (a provisional estimate put it at 1.2 trillion yen). The lender institutions have prepaid for their share of loss-taking by establishing a fund of 1 trillion yen whose interest earnings will be used to pay for the second-round losses. In addition, they have established another fund of 0.9 trillion yen whose interest earnings will repay the government’s initial contribution (0.68 trillion yen) for the first-round losses. The founder banks shouldered the largest share of the contribution to the two funds, while the Bank of Japan was also a contributor. All in all, the resolution scheme introduced in 1996 has finally eliminated the uncertainty which had been hanging like dark clouds over Japan’s banking sector.5 It should be noted, however, that banks’ contributions to the two funds totaling 1.9 trillion yen will generate no earnings to banks and thus will remain as “non-performing” assets in their portfolios for the next 15 years. In addition, the below-market-rate lending to the HALC (banks lent about 4.5 trillion yen) will lower bank earnings as well. The foregone interest earnings are needed, in effect, to compensate for the generous repayment of agricultural cooperatives’ loans to the housing loan companies.

III. FINANCIAL

DEREGULATION

A. Interest Rate Deregulation The government’s approach to deregulating interest rate controls was quite gradualist. The first step of liberalizing bank deposit interest rates was the introduction of large-denomination CDs (certificates of deposit) with unregulated rates in 1979. (Note that bank lending rates had not been under rigid controls.)6 After several years

Developments

in Japan’s Financial Sector

235

of no further deregulation measures, the government started to decontrol interest rates step by step from 1985 when new large-denomination MMCs (money market certificates) and large-denomination time deposits were permitted to be issued with unregulated rates. Since then, their minimum denomination was gradually lowered, and the restrictions on their maturity terms were also eased. The protracted process of deregulation was finally completed in 1994 when the interest rate control on demand deposits was removed.7 A major driving force for interest rate deregulation was the large issuance of government bonds. The government started issuing bonds in large amounts to finance increased budgetary deficits since the mid-1970s. During much of the post-World War II period up until the mid-1970s government deficit had been kept either at zero or small. In those years, the government placed its bonds carrying regulated low interest rates onto private banks. The Bank of Japan purchased those bonds from private banks one year after their issuance, and the resulting monetary expansion effectively met the increasing demand for money due to rapid economic growth during the postwar high growth era. This practice of accommodating government bond issuance became impossible when government deficit ballooned from the mid-1970s. The government had to let the market determine its bonds’ interest rates so as to make them attractive. With the advent of a large unregulated market for government bonds, deregulating other interest rates became the inevitable next step. Another important factor for interest rate deregulation was the pressure from the US in the early 1980s. The US Gove~ment demanded that Japan’s financial sector be liberalized. Its intention was that freer financial markets in Japan would help redress the high dollar problem at that time by increasing the demand for the yen, and that it would also help expand business opportunities for American financial institutions. As part of the Japan-US agreement in 1984, the Japanese government committed itself to interest rate deregulation. As mentioned earlier, interest rate deregulation proceeded slowly, and full deregulation occurred much later than other major industrialized economies and even some of East Asian developing economies such as Singapore, Taiwan, and the Philippines. The government had taken a gradualist approach so as to mitigate adverse impacts on smaller depository institutions like weaker regional banks and credit cooperatives. Gradual phasing out of protection did not guarantee sound financial conditions of smaller institutions, however. In fact, as discussed earlier, many of smaller institutions as well as large banks have been experiencing dire financial difficulties due to imprudent lending during the late 1980s. On the other hand, the sIow pace of interest rate deregulation had some undesirable effects on the economy. First, depositors were kept denied higher deposit interest rates for longer than necessary. Some portion of income transfer from depositors to banks was likely passed on to corporate borrowers, while the remaining was retained as economic rents (or excess profits) by banks. According to Tsutsui et al. (1995), during the 1960s when tight controls on interest rates were in place, income transfer from depositors to

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JOURNAL OF ASIAN ECONOMICS 8(2), 1997

banks is estimated to have totaled 0.6-1.1 trillion yen per year (about 2% of GDP). Roughly, 60% of such income transfer was passed on to borrowers during that period. Second, the staggered deregulation process in which large-denomination deposits were deregulated earlier meant that corporations and wealthy individuals were better off at the expense of smaller depositors. This negative side effect was aggravated during the bubble boom when many corporations could easily increased their profits by raising funds through low-cost equity-related finance and depositing them as largedenomination time deposits which paid higher interest rates. Before ending discussions on interest rate deregulation, let us briefly discuss about the pre-deregulation period. During the post-war period through the mid-1970s most interest rates were tightly regulated in Japan. Intense non-price competition by banks to attract deposits and the rationed issuance of corporate bonds whose interests were also regulated during that period clearly indicate that government regulations were binding. That is, interest rates were kept below market-clearing levels. It should be noted, however, that government regulations did not suppress interest rates very much. In other words, financial repression was mild. Contrary to the view popular in Japan that the government put the policy of “artificially low interest rates” in place to promote growth during the high growth era, “the Japanese interest rates were at substantially high levels during the 1950s and 1960s not only in real terms but also in nominal terms.” (Horiuchi, 1984). While cross-country studies have shown that financial repression caused by tight controls on interest rates coupled with high inflation suppresses long-term growth, Japan’s government regulations led to only mild financial repression, so that rapid growth was not stymied. B. Deregulation

of the Separation

of Functions

Japan’s financial sector has been compartmentalized due to government regulations that separate functions different types of financial institutions can perform. First, banking is separated from securities business. This prescription is similar to the US Glass-Steagall Act’s provisions that separate commercial and investment banking. In Japan, banks are prohibited from underwriting, dealing, or brokering securities except public-sector bonds, and security companies in turn are prohibited from conducting banking business including foreign exchange transactions. It is important to note, however, that large banks, particularly, long-term credit banks like the Industrial Bank of Japan have played major, often dominant roles as consignors in the issuance of corporate bonds. Second, the banking sector itself is compartmentalized. Three long-term credit banks and several trust banks have specialized in long-term lending for capital spending, and other banks (city banks and regional banks) have provided mainly short-term lending. The latter group of banks (commercial banks) have not been proscribed to lend long, but they had been permitted to offer deposits of up to only two years until recently so that there had been limits for them to extend long-term loans because of

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maturity mismatch risks. On the other hand, long-term credit banks have been permitted to issue bank debentures of up to five-year’s maturity, and trust banks have been permitted to issue time-deposit-like loan trusts of up to five-year’s maturity. While commercial banks in the US can conduct trust business, trust business in Japan is the territory reserved for trust banks alone. Among commercial banks, city banks have been allowed to branch mainly in large cities under strict branching regulation, while local markets have been reserved for regional banks and other smaller depository institutions. Because of the branching regulations, during the rapid growth era of the 1950s and 60s city banks borrowed heavily from fund-rich regional banks and other depository institutions in domestic interbank markets.’ In 1994, a major reform termed as the “financial sector reform” was introduced to relax the long-standing policy of the separation of functions. Prior to the 1994 reform, some deregulatory measures had been introduced, but they were of limited significance.’ Under the new framework introduced in 1994, different types of financial institutions can enter each other’s business areas by setting up subsidiaries. New securities companies (17 in September 1996), established as 100% subsidiaries of major banks, have already been in operation. Major securities companies and major banks have established trust bank subsidiaries (16 in September 1996) to enter trust business and banking. lo Note that there has been no new long-term credit bank nor commercial (shortterm) bank subsidiaries for the following reasons. Barriers between long-term and commercial banking have recently been lowered, as commercial banks such as city banks have been allowed to offer longer-maturity time deposits (up to three years in 199 1, five years in 1994, and no limit to maturity in 1995). Thus, there is no need to set up a long-term credit bank subsidiary to enter long-term credit banking.” Note also that securities companies can now enter banking business (deposit-taking, lending, and foreign exchange transactions) as well as trust business through their new trust bank subsidiaries, so that there is no need to set up a (long-term credit or commercial) bank subsidiary. While strict branching regulations had been an effective tool to segregate different groups of banks, the government relaxed them partially in 1995, and plans to eliminate the remaining restrictions in 1997. In April 1996, the government took down the restriction prohibiting life insurance companies and non-life insurance companies from entering each other’s business. Now, life and non-life insurance companies can enter each other’s business by establishing subsidiaries. C. Remaining Regulations The 1994 reform was a major transformation of Japan’s financial sector where no new entry to banking and securities business had been allowed for four decades (since

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the mid-1950s) except some foreign banks and foreign securities companies. The reform has already led to increased competition in some areas. In particular, new securities company subsidiaries of large banks have captured sizable market shares in underwriting of corporate straight bonds. From April to September 1996, new securities companies were chief underwriters to one third of the total issuance of domestic straight bonds (see Figure 1). Yet there remain important restrictions on activities of new subsidiaries, and unwieldy regulations on the relationship between banks and their securities company subsidiaries. Brokerage fees for securities still remain regulated. Restrictions on Activities of Subsidiaries. Banks are now able to enter securities business through their subsidiaries. But there are stiff restrictions on what new securities companies can do in order to protect old securities companies, particularly smaller inefficient ones. First and foremost, new securities companies are prohibited from doing business involving company stocks. That is, underwriting, dealing, and brokering company stocks are not permitted for them. Second, they are permitted to underwrite convertible bonds and warrant bonds, but they cannot deal nor broker such securities. Third,.they cannot handle stock index futures and options. Thus, the main line of business that is open to new securities companies is corporate straight bonds.

Foreign companies 1% ‘-1

/ Bank subsidiaries 11

Other old 1%

1 33.2% ,

&

v>

FIGURE 1. Source:“Kinyu Note:

Share of Underwriting of Straight Bonds - 1996 April to September -

Business,” March 1996. The share of the yen-amount issuance underwritten by each company as chief underwriter.

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in Japan’s Financial Sector

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New trust banks, which are subsidiaries of major securities companies and major banks, are also proscribed not to engage in certain activities. Among other things, new trust banks are not permitted to trustee pension funds. With this restriction, old trust banks are protected because trusteeship of pension funds is a growing business in Japan. New trust banks cannot manage individually-operated designated money trusts, either. Thus, the main activities for new trust banks include trusteeship of mutual funds and banking. Regulations on the Relationship Between Parent and Subsidiary. The government has also imposed various restrictions on the relationship between a bank and its securities company subsidiary. Some of such restrictions are fire wall regulations intended to avoid conflicts of interest. They include a ban on concurrent appointment of board members of the two institutions, and a ban on unfair tie-in sale of banking and security-related services. But there are other regulations, the main purpose of which is simply to handicap large powerful banks in the competition in securities business. For example, a chief executive officer of a securities company subsidiary cannot return to the parent bank as a board member. Over 50% of the staff of a securities company subsidiary or a trust bank subsidiary must be permanent staff (that is, staff not seconded from its parent company) within five years after establishment. Also, a bank and its securities company subsidiary cannot have their branches or offices in the same building. As mentioned earlier, concerns about conflicts of interest are the basis for some restrictions on the relations between a bank and its subsidiary securities company. The prevention of conflicts of interest is certainly a legitimate policy concern. There is a strong case, however, that conflicts of interest would not be a major problem if competition is encouraged and if proper arrangements such as disclosure requirements are in place. It is noteworthy that the US has recently been moving towards relaxing some of its fire wall restrictions. High fire walls would deny potential benefits to be gained from the economies of scope. Price Regulation (security brokerage fee and insurance premium). Pr i c e s of financial services need to be determined competitively. While deregulation of interest rates have recently been completed, brokerage fees for securities remain regulated. Premiums for non-life insurance are determined uncompetitively by government-sanctioned cartels of insurance companies. The government regulates brokerage fees for stocks and bonds. Note that brokerage fees are the main revenue source for smaller securities companies. Although the regulated fee schedule has a cascading structure with lower rates applied to large transactions, brokering large-amount orders has provided cozy revenues for securities companies. In 1994, the government deregulated fees for large transactions of stocks beyond one billion yen, with the result that those fees have since been reduced significantly due to competition. Such large transactions amount to only about 10% of total

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transaction of stocks, however. Brokerage fees for bonds remain regulated including those for large transactions. Cozy revenues ensured by fixed or uncompetitively-determined fees were a major background for the stock market scandal uncovered in 1991. Almost all of major securities companies unfairly compensated corporate customers for their huge capital losses incurred when stock prices fell from 1990. At that time, top executives including the president of Nomura Securities, Japan’s largest securities company, took responsibility and resigned. Note that unfair kick-back practices had been common in the US as well, before fees were deregulated in 1975. There is a concern in Japan that the deregulation of brokerage fees would result in lower fees for larger transactions but higher fees for smaller transactions, with the result that Japan’s already low share of stock ownership by individuals would be further lowered. But, once fees are liberalized, discount brokers are expected to emerge like in the US, so that fees would be effectively lowered including those for small transactions. In this connection, it is important to permit banks to broker securities over the counter at their branches as discount brokers in order to promote competition. Underwriting fees and bond consignment fees are not regulated unlike brokerage fees, but they do not appear to have been determined competitively, and consignment fees in particular have been high by international standards. However, the bond issuance market has become more competitive since the 1994 reform, and there are some signs that consignment fees have become somewhat lower especially for lowergraded short-term bonds (Nakakita, 1995). Premiums for non-life insurance policies are determined by government-sanctioned rate-setting associations whose members are insurance companies. Member companies are obliged to apply the same premiums, so that there is no price competition. This arrangement is, in effect, price-setting cartels, but it is exempt from the Anti-Monopoly Law by a special legislation. In December 1996, however, the government pledged to liberalize premiums for fire, casualty, and automobile insurance by July 1998, as part of the agreements of long-drawn Japan-US negotiations on the liberalization of Japan’s insurance markets.12 Portfolio Allocation Rules for Insurance Companies and Pension Funds. The government has put in place quantitative restrictions on the portfolio compositions of insurance companies and pension funds with an aim to ensure the safety of their investments. For insurance companies, investment in domestic company stocks should be less than 30% of their total assets, investment in foreign assets should be less than 30%, and investment in real estate should be less than 20%. Pension funds for company employees are also subject to similar regulations on portfolio allocation. There are two types of employee pensions that are managed by employers, which are mostly large companies. One is the “Kousei Nenkin Kikin plans” that are delegated to manage the public pension for employees as the govemment’s agent and also provide additional pension benefits above those of the public

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pension program. The other is the “Tekikaku Taishoku Nenkin plans” that are private pensions and are eligible for favorable tax treatments. While both types of pension funds are subject to portfolio allocation rules (more than 50% in safe assets such as government bonds, less than 30% in domestic company stocks, less than 30% in foreign assets, and less than 20% in real estate), pension funds of the second type (Tekikaku) are subject to stiffer restrictions. First, when a Tekikaku pension fund entrusts, say, two trust banks to manage its portfolios, each trust bank must meet the above-mentioned allocation rules respectively. Second, pension funds of the first type (Kousei) may have part of their portfolios entrusted to investment advisory companies and may also manage part of their portfolios on their own under certain restrictions, but this is not possible with pension funds of the second type.13 These direct restrictions on portfolio management of insurance companies and pension funds are likely detrimental to most efficient allocation of their funds. The government may need to consider introducing the “prudent person” rule adopted in the US and Great Britain. This rule requires portfolio managers to manage their funds in a responsible manner such that there is proper diversification and liquidity potentials in portfolio holdings. D. What Needs to be Done? As mentioned earlier, Prime Minister Hashimoto recently pledged to introduce Japan’s Big Bang by the year 2001. The specifics have not, as yet, been fully worked out. As a working group of The Economic Council which is an advisory body for the Prime Minister recently recommended, the reform should involve an extensive elimination of remaining restrictions, and a major realignment of existing regulatory arrangements (Economic Council, 1996). This time, the government appears to be more committed to major changes than ever before. Among other things, the following directions are important. Elimination of Remaining Regulations. All the remaining regulations discussed earlier need to be removed as quickly as possible. For example, the government should eliminate the restrictions that have been put on new securities companies and new trust banks, and should liberalize brokerage fees. Stiff restrictions on portfolio management of insurance companies and pension funds need to be replaced by less interventionist regulations which ensure higher returns as well as the safety of funds. Active Market Entry and Introduction of Financial-Services Holding Companies. More active market entry takes on critical importance. To date, the government has permitted banks and securities companies to enter each other’s markets and permitted life insurance and non-life insurance companies to do the same. However, banks and securities companies should also be permitted to enter insurance business, and insurance companies should be permitted to enter banking and securities busi-

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ness. Furthermore, market entry into those financial services should be made open to non-financial companies as well. When a variety of financial services can be provided by an affiliate company group, an apex holding company, if legalized, could manage the company group more efficiently. The government is now preparing a draft legislation to amend the AntiMonopoly Law to reinstate holding companies for not only financial companies but also non-financial companies. It is important for a financial-services holding company not to be prohibited from servicing a whole array of financial services including banking, security-related business, mutual funds, and insurances.

Prompt Corrective Actions and Disclosure Improvement. Early response capabilities of bank supervisors need to be strengthened. A new system of “prompt corrective actions” will become effective in April 1998 (Ministry ofFinance, 1996). The US has adopted prompt corrective measures since 1992, and Japan’s new measures modeled them. The main pillar of the new system is the introduction of supervisory actions based on capital adequacy standards. For banks that engage in international operations, the BIS’s capital adequacy ratio (tier-one plus tier-two capital divided by risk-weighted assets) is to be used as yardstick. For smaller non-international banks (including cooperative-type financial institutions), a domestic standard of capital adequacy ratio (tier-one capital plus subordinate debts divided by risk-weighted assets) is to be used as yardstick. When the capital adequacy ratio falls below 8% for international banks and 4% for non-international banks, the government orders the bank to prepare and implement a plan for improvement. When the ratio falls below 4% for international banks and 2% for non-international banks, the government orders the bank to take certain corrective actions such as submitting a plan to raise equity, limiting the expansion of assets, and reducing dividend payments and executive salaries. When the ratio falls below O%, the government orders the bank to close operations partially or entirely. It can be noted that the new rules are less stringent to smaller banks, to the extent that they can add subordinate debts to tier-one capital as numerator of the capital adequacy ratio, and yet the upper threshold for corrective actions is 4% for them. Veracious disclosure of bad loans is particularly important in imposing market discipline on banks and in helping banks to adequately control exposure to bad loans. To this end, banks must introduce more rigorous internal and external auditing. They also need to disclose their internal criteria for loan loss provisioning, so that markets can judge which banks are more prudent in controlling the exposure to bad loans. All cooperative-type financial institutions need to disclose their bad loans individually.

Readiness for Future Bank Failures. With the introduction of the prompt corrective measures and the planned “Big Bang” which would increase competitive pressure in the banking sector, some more banks and cooperative-type financial institutions may fail and need to be shut down. The government has committed itself to continuing to guarantee all deposits beyond the legal limit of 10 million

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yen until the year 2001. Given the weakened financial conditions of some banks and cooperative-type financial institutions, the government may have to inject more public funds for the resolution of bank failures. In June 1996, new legislation was introduced to cope with future bank failures. The premiums for deposit insurance were raised seven-fold, in order to replenish the dwindling insurance fund. In view of the need to prepare for further failures of credit cooperatives which are generally weak, the government has put in place, for a fiveyears’ time, a resolution scheme for failed credit cooperatives. As part of this scheme, the government has committed itself to providing public money to pay for the ultimate cost of resolution. The new Resolution and Collection Bank was also established to take over failed credit cooperatives, when there are no healthier banks or credit cooperatives willing to take them over. This Bank is to be wound up in tenyears’ time. These are important steps forward. Yet, further measures are needed to cope with possible bank failures. First, there is a need to put in place resolution schemes for the failure of banks and other depository institutions other than credit cooperatives. Second, resolution process needs to be as transparent as possible. To date, the government has played a major role in finding other banks to take over failed institutions somewhat like a go-between of arranged marriage. Bidding should be introduced when a failed institution is sold entirely or partially, as is done in the US. Third, risk-based premiums for deposit insurance need to be introduced. While the premiums have recently been raised substantially as mentioned above, a flat rate is applied to all banks regardless of financial health. This would result in moral hazard and thus increase the risk of more bank failures in a more deregulated environment. Acknowledgment: I am grateful for useful discussions with Messrs. Takamasa Yamaoka and Shigeru Sugihara of the Economic Planning Agency. The views expressed in this paper are my own and do not represent those of the EPA.

NOTES 1. While Britain’s Big Bang in 1986 was mainly the reform of securities markets, Japan’s planned Big Bang will be more extensive, covering the entire financial sector including banking, securities business, insurance, and pension funds. 2. Japan’s banking sector consists of the 20 major banks, about 130 regional banks, and many smaller cooperative-type financial institutions that include Shin&ins, credit unions, and agricultural cooperatives. In April 1996, two city banks (Mitsubishi Bank and the Bank of Tokyo) merged into the new Tokyo-Mitsubishi Bank. 3. To be more precise, a part of bad loan charges (general loan loss provision) is deducted to obtain net core profit. 4. Generally, banks have an incentive to sell bad loans with low residual values to the CCPC, because banks could get larger tax reliefs from tax-free write-offs for similar incidental costs associated with loan sales. Accordingly, the average residual value of bad loans could be larger than 40%.

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5. Strictly speaking, it is not clear whether banks would be asked to pay an additional amount at the time of the HLAC’s closure, if the second-round losses are larger than initially expected. 6. Interest rates of loans of less-than-one-year terms had been subject to legal ceilings, and they had been determined below the ceilings by a cartel of banks. Longer-term lending rates, not subject to legal ceilings, had been determined also by the cartel. The government could influence the banks’ decision through moral suasion. It should be noted, however, that banks had raised the effective rates on bank loans above contracted rates by requiring borrowers to hold substantial amounts of compensating balances which paid low deposit interest rates. 7. It is noted that the ban on interest-paying checking accounts remains. 8. In more recent years, trust banks have become the most important supplier of funds in the interbank markets, while city banks have remained chronic borrowers. Trust banks use the short-term interbank markets as temporary abode of their trust account portfolios. 9. For example, during the early 1980s banks were allowed to sell newly-issued government bonds at their branch offices and to deal them. In turn, security companies were allowed to offer demand-deposit-like mutual funds incorporating medium-term central government bonds, and also to extend loans as long as their borrowers offered government bonds as collateral. In 1991, city banks and other commercial banks were allowed to offer three-year deposits. 10. While major banks (city banks and long-term credit banks) can enter trust business only through subsidiaries, regional banks and other regional depository institutions are permitted to engage in trust business without setting up a subsidiary, out of consideration of their small size. 11. Commercial banks are still not permitted to issue bank debentures, whereas long-tern credit banks continue to issue them. 12. Separately, the legislation in 1996 stipulated that premiums for marine insurance be liberalized by 1998. Recently, insurance companies agreed to abolish the rate-setting association and liberalize premiums one year earlier, namely, in April 1997. 13. From April 1996, well-managed pension funds of the first type are exempt from the 50-30-3020% rule, but they remain very limited in number. From April 1997, the government is to eliminate the 50-30-30-20% rule for all pension funds of the second type.

REFERENCES Economic Council. 1996. Report of the Working Group on Finance: For Vitalization of Japan’s Financial System (in Japanese), Government of Japan, October. Federation of Bankers Associations of Japan. Analysis of Financial Statements of All Banks, Various issues. Tokyo. Horiuchi, A. 1984. “The ‘Low Interest Rate Policy’ and Economic Growth in Postwar Japan,” The Developing Economies, December, Institute of Developing Economies, Tokyo. Kinyu Business (Financial Business), March 1997 issue featuring financial instituions’ mid-year financial statements in September 1996, Toyo Keizai, Tokyo. Ministry of Finance. 1996. Report of the Study Group on Prompt Corrective Measures (in Japanese), December, Government of Japan. Nakakita, T. 1995. The Rebirth of the Banking Industry (in Japanese), Nihon Keizai Shinbun-sha, Tokyo. Organization for Economic Cooperation and Development. Economic Surveys: Japan, 199111992, 1993/1994, and 19950996, Paris. Tsutsui, Y. et al. 1995. “Low Interest Rate Policy and Efficiency of the Banking Industry” (in Japanese), IPTP Review, bl. 6, March, Institute for Posts and Telecommunications Policy (IPTP), Ministry of Posts and Telecommunications, Government of Japan.