No. 36 — September 22,, 2000


Weekly Review

--- by Douglas Ostrom

A comparison of this article, the Japan Economic Institute's final discussion of what has come to be known as the crisis in Japan's banking system, with A Savings And Loan-Style Crisis For Japan? (see JEI Report No. 37A, October 2, 1992) leads to the inescapable conclusion that the risk of severe distress in that country's financial sector remains — even after eight years. In 2000, as in 1992, overall economic conditions will determine whether a full-blown emergency develops or if the problems continue to dissipate, as they appear to have done since 1997.

Tokyo, of course, has instituted a number of important reforms. Financial authorities now are much quicker to go after troubled institutions than they were before. They also have more carrots — trillions of yen in public money — as well as sticks — so-called prompt corrective action — at their disposal. The Big Bang financial deregulation program, currently nearing completion, has increased competition among financial institutions and expanded consumer choice, although its beneficial impact on bank health is much more debatable. The banking industry has responded to the changing business environment by launching a series of mergers and link-ups. Whether these combinations will advance the cause of bank efficiency remains in doubt, however.

The track record of Nippon Credit Bank, Ltd. exemplifies both what has changed and what has not. The September 1 sale of NCB to a consortium spearheaded by Softbank Corp. resolved, for the moment at least, the fate of the largest remaining financial institution known to be seriously troubled. Although Moody's Investors Service Inc. and others identified the bank more than five years ago as unlikely to survive without outside assistance, government banking officials and industry executives alike crossed their fingers and hoped for the best, going so far as to orchestrate a joint public-private bailout for NCB in June 1996.

In the end, 34 financial institutions purchased ¥210 billion ($1.9 billion at ¥110=$1.00) worth of new shares issued by NCB. When the investment bank collapsed anyway in December 1998 and was nationalized (see JEI Report No. 47B, December 18, 1998), the shares became worthless, and the buyers lost their money. To revitalize the bank, Tokyo has pumped in at least ¥4 trillion ($36.4 billion) in new capital. It is expecting a request, probably in October, for ¥260 billion ($2.4 billion) more from the new owners.

Press reports have touted the "new" NCB's ability to leverage the resources of Softbank's vast number of Internet-related affiliates and venture-capital firms, yet, despite its unorthodox ownership, the revived NCB — to be renamed Aozora (Blue Sky) Bank, Ltd. in January — looks suspiciously like the old bank. The new bank's president, Tadayo Honma, while at the Bank of Japan, helped solicit capital for NCB from other banks. His September 20 suicide dealt the bank a severe blow.

Moreover, NCB plans to focus on relationships with the nation's regional banks, many of which took a "haircut" from past investments in the lender, and with small and midsize firms, whose financial difficulties have led to an expanded government credit-guarantee scheme. Both groups are traditional NCB clients. In what amounted to a vote of no confidence, Moody's in early September gave a rating of E+ to the new NCB, up only from the rock-bottom E rating assigned back in 1995, when NCB's problems first emerged (see JEI Report No. 33B, September 1, 1995).

Japanese financial policymakers naturally remain publicly upbeat about NCB and other big banks. They have expressed optimism about the pending combination involving Industrial Bank of Japan, Ltd., Fuji Bank, Ltd. and Dai-Ichi Kangyo Bank, Ltd., which are scheduled to form a holding company, Mizuho Holdings, Inc., September 29, as well as about the proposed merger of Sakura Bank, Ltd. and Sumitomo Bank, Ltd. and the tie-up of Sanwa Bank, Ltd. and Tokai Bank, Ltd. In addition, Bank of Tokyo-Mitsubishi, Ltd., currently Japan's biggest commercial bank in terms of assets and its healthiest, and Mitsubishi Trust & Banking Corp. will form a holding company next April after combining their trust operations October 1 (see JEI Report No. 17B, April 28, 2000).

As they have for some time, officials imply that the financial sector's remaining problems are concentrated among smaller banking institutions, such as regional and cooperative banks, and within the ranks of insurers. In fact, small lenders are the target of most supervisory action right now. In early September, Tokyo announced that, out of several hundred such companies, 51 small banks, cooperatives — both shinkin (credit associations) and shinkumi (credit cooperatives) — and financial institutions of various other types had been on the receiving end of orders for prompt corrective action in the two-year period through May. Separately, leading business daily Nihon Keizai Shimbun reported that an additional 19 institutions were candidates for such treatment based on low capital/asset ratios. Unless the target institutions fail, the identity of such banks generally is not revealed.

Insurers also continue to restructure, either voluntarily or under duress. In late August, Taisho Life Insurance Co. was ordered to cease most operations, effectively making it the fourth insurance company to fail since Nissan Mutual Life Insurance Co. went bust in 1997 (see JEI Report No. 17B, May 2, 1997). Around the same time, Yasuda Fire & Marine Insurance Co., Ltd. announced a broad tie-up with Dai-Ichi Mutual Life Insurance Co. Moreover, in mid-September, Tokio Marine & Fire Insurance Co., Ltd., Japan's biggest property and casualty policy writer, said that it would join forces with the nation's fifth-largest life insurer, Asahi Mutual Life Insurance Co., and midsize Nichido Fire & Marine Insurance Co., Ltd. in an equal partnership, thereby confirming reports that had circulated for weeks. Not until 2003, however, will the three form a holding company.

Appearances aside, the windup, at least for the moment, of the NCB mess and the moves to address the well-publicized problems of smaller lenders and insurance companies do not mean that resolution of Japan's financial crisis now just requires what amounts to a cleanup operation of a few pockets where weak balance sheets persist. Only 10 days after NCB passed into private hands, the International Monetary Fund provided a reminder that the financial footing of Japan's biggest banks still is precarious.

The IMF analysis was in the form of an appendix to its annual international capital markets report and was limited to 17 large banks. It excluded NCB and the former Long-Term Credit Bank of Japan, Ltd., the latter of which was privatized earlier and now operates as Shinsei Bank, Ltd. (see JEI Report No. 8B, February 25, 2000). IMF researchers focused on Japanese banks reputed, based on conventional wisdom, to be the healthiest, not to mention the most important internationally. Nevertheless, they found serious problems.

Using what they called "representative" nongovernmental estimates of bad loans, making conjectures regarding loans that have been restructured and assuming the possible migration of doubtful loans to the bad-loan category, the authors of the IMF study figured that the 17 banks might require as much as ¥73.5 trillion ($668.2 billion) in reserves for bad loans; however, their reserves totaled only ¥52.3 trillion ($475.5 billion) as of March 31, 2000. In other words, these banks could have unrealized losses of as much as ¥21.2 trillion ($192.7 billion).

If realized, losses of this magnitude would deplete 93.8 percent of so-called Tier I capital, which suggests that the 17 large banks could, on average, end up close to insolvent under certain extreme assumptions. One such premise is that these banks also would lose their Tier II capital, much of which consists of unrealized gains on equities. Of course, an increase in bad loans might well coincide with an economic downturn that would wipe out such paper profits. Another IMF assumption is that all the losses would be realized at once. A third is that there would be no offset from operating profits on other activities.

These are not the IMF's only worrisome assumptions. A rapid run-up in interest rates could create capital losses for banks, which have invested heavily in securities instead of lending money. Given the low level of long-term rates and the prospect that government budget deficits will remain large, such a rise cannot be ruled out. Moreover, as the IMF said, "a considerable portion of the major banks' subordinated debt and other limited life capital liabilities will mature in the next two years, so banks will need to turn to the market for substantial amounts of equity before long." In short, both a potential interest-rate increase and the reality of refinancing mean that major Japanese banks will have to struggle to keep their Tier I equity at existing levels, let alone increase it.

Moreover, recent developments have served to underline the problems surrounding restructuring, one of the factors that the IMF noted could be a pitfall for big banks. On September 18, Sumitomo Bank announced that it would forgive loans totaling as much as ¥234 billion ($2.1 billion) to troubled major contractor Kumagai Gumi Co., Ltd. Other banks, perhaps including Shinsei Bank, may join in the restructuring of loans to Kumagai Gumi and to other struggling businesses in the construction industry, taking enormous losses in the process. For instance, Hazama Corp., a major civil engineering company, reportedly has persuaded Shinsei Bank and NCB, among others, to forgive loans amounting to ¥105 billion ($954.5 million).

In other words, the IMF estimate implies a banking meltdown under extreme but not unimaginable circumstances — exactly the possibility that faced banks in 1992. At that time, few analysts expected serious, protracted problems to emerge in the Japanese banking industry because they could not have anticipated that the subsequent eight years would be the worst ones for the economy in the postwar period. If macroeconomic history does not repeat itself, the mop-up scenario will prevail. Large banks will regain their health, and the problems of smaller institutions eventually will wind down as a result of continued restructuring. If economic conditions remain difficult or worsen, Japan's banking crisis will be back.

Countermeasures could be enormously expensive. The financial crisis has cost the government an estimated ¥25 trillion ($227.3 billion) to date. As such, the implied comparison with the American savings and loan crisis (roughly $150 billion in help from Washington), which seemed in 1992 to exaggerate Japan's problems, turns out to have understated them by some measures. If the last eight years end up being only the preliminary round, the cost to Tokyo obviously will be much greater.

For U.S. policymakers and the American public, the pessimistic scenario may be less alarming than it appears. In the past decade, Japanese authorities have learned a great deal about crisis management of financial institutions. No doubt they would move quickly to limit the damage from the failure or the near collapse of a major bank, regardless of the monetary burden, thereby making contagion effects in other markets unlikely. The real cost to Washington would come from Tokyo's inattention to international affairs as it struggled with the ensuing economic, budgetary and political fallout at home.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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