Even though the efforts of Japanese banking authorities to deal with a huge amount of nonperforming and underperforming loans have hogged the media spotlight, significant developments worth watching are taking place in Japan's other financial markets. While the Ministry of Finance continues to push the reform process forward, its goals are becoming less clear. MOF would like to convince outsiders that "business as usual" is underway, but the roots of the bad-loan crisis are so deep and its shadow is so big that the crisis affects Japan's entire financial system and the process of financial market reform.
Indeed, at the moment the Finance Ministry finds itself the target of intense scrutiny by a Japanese public thirsting for punishment and by Japanese politicians intent on placing the responsibility for the bad-loan situation on someone else's shoulders. Although the ministry has weathered previous bureaucratic reform campaigns, current proponents of change are more numerous and powerful than before. It is far from certain, however, that meaningful alterations to MOF's structure will be enacted.
A mountain of nonperforming and underperforming loans the most damaging legacy of the rapid deflation after the late 1980s' speculative boom in real estate and stocks (the so-called bubble economy) has shaken public confidence in the country's banking system, dominated Japanese media headlines and become a major domestic political issue (see JEI Report No. 44A, December 1, 1995). The hubbub has all but obscured other financial market matters, some of which show promising signs of change and reform. At the same time shock waves from the bad-loan crisis have spread into most financial areas, making further reforms more difficult even as they make change more necessary.
Although financial analysts as well as banking and monetary authorities have been aware of the bad-loan problem for several years, only recently has the public come to appreciate its severe consequences. Several events crystallized the issue for the average citizen:
Japanese banks, the group most affected by the bad-loan mess, are responding in several ways:
In the consumer credit field, however, banks still have a long way to go. In the past consumer credit companies were considered barely respectable because of usurious rates (at times above 100 percent) and overzealous efforts to collect from customers. Since 1983, when a law was passed capping consumer credit rates at 41.2 percent and bringing consumer credit firms under tighter regulation by the Ministry of International Trade and Industry and MOF, consumer credit firms have rehabilitated their standing with the borrowing public by providing quick loan approvals combined with moderate interest charges. Commercial banks, despite paying lip service to such goals as improving retail operations for individuals, do not come close to providing a similar level of service, according to Japanese press reports.6 It can be difficult for an individual to open an account at one of Japan's top nationwide commercial banks, much less get a personal loan.
If the bad-loan situation puts enough pressure on commercial banks, the future of Japan's government-owned and -operated postal savings system could be moved to the front burner. Japanese banks long have looked at the huge postal savings system as a competitor that enjoys unfair advantages thanks to its status as a government entity. These institutions cannot match the features of the postal system's most popular deposit the fixed-rate time deposit or teigaku chokin. Among its competitive pluses are an interest rate as much as 1 percentage point higher than what is available at a commercial bank, interest compounded every six months instead of annually, a maturity of up to 10 years and no withdrawal penalties after the first six months of opening the account. Bankers also cite the following postal savings system advantages that they cannot match: more branches and automated teller machines (24,400 post office outlets versus 16,000 bank offices), no reserve cash requirements or deposit insurance premiums, exemption from both local and national taxes, and backing by the full faith and credit of the Japanese government. With the failure of several Japanese banks and credit cooperatives over the past year, anxiety has increased among depositors about the health of banks and alternative savings institutions. It is not surprising, therefore, that the outstanding balance of deposits held by the postal savings system reached record levels in 1995, passing the ¥200 trillion ($2 trillion) mark in June. The postal savings system controls about one-third of all Japanese individual deposits (see Table), a fact that gives weight to bankers' perceptions of the system as a potent competitor.
For these reasons bank executives are pressing harder than ever before for reform of the postal savings system. Ideally they would like the government to abolish the system, but this is unlikely to happen since two powerful ministries Finance as well as Posts and Telecommunications derive important benefits from the arrangement. The current ruling coalition government also has a vested interest in maintaining the system. Private operators of post offices and postal savings outlets, which constitute about 75 percent of all post offices in Japan, support one member of the ruling coalition, the Liberal Democratic Party. At the same time the Japan Postal Workers Union supports another member of the coalition, the Social Democratic Party of Japan. If abolition is unlikely, then bankers at least would like the postal system's advantages to be nullified or moderated. While the postal system's interest rate advantage could be erased, it would be politically difficult to pare the system's size, its tax-exempt status, its freedom from reserve requirements and, especially, its bankrupt-proof nature as a government entity.
According to recent consumer surveys, the secret of the postal savings system's popularity also may have much to do with the services and the convenience it provides. A recent poll of 3,000 Japanese savers showed that 50.7 percent were dissatisfied with the products and the services offered by financial institutions since the beginning of deregulation in the 1980s. When respondents were asked to pick which financial institutions were most eager to improve services, 24.1 percent selected postal savings outlets, 17 percent chose regional banks, 11.5 percent cited credit associations and only 10.4 percent picked nationwide commercial banks.7 Other newspaper articles underscore the strong appeal of the higher returns and the greater security offered by the postal system but also reiterate the high levels of customer satisfaction that it has earned. "One of the reasons why postal savings have thrived in Japan is that they are constantly improving their financial services," one financial analyst has been quoted as saying. "For example, at post offices you can pay utility bills, settle credit card payments and use automatic teller machines."8
The magnitude of the challenge faced by bankers seeking major reforms of the postal savings system is clear from these articles. A further indication of the competition they face is MPT's ¥2.9 billion ($29 million) advertising budget for the postal system in FY 1995. When discussing why the system has a nationwide network of outlets as well as 21,700 ATMs, an MPT official noted, " we go so far as to operate in underpopulated areas, regardless of cost."9 Obviously, for-profit firms find competing with an operation that is relatively unconcerned about costs rather difficult. Customers also may be indifferent to banks' complaints of unfair competition: "We don't really care about which [side] is right or wrong," one postal system patron is quoted as saying by a reporter. "We just want to [get the most out of our money]."10
One area of deregulation showcased by MOF has been its effort to allow banks and securities firms to compete somewhat head-to-head. Article 65 of the Securities and Exchange Law acts as a regulatory barrier between commercial and investment banking in a fashion analogous to the Glass-Steagall Act here. The Financial System Reform Act, which went into effect at the start of FY 1993, opened a door in this barrier by allowing banks and brokerages to establish wholly owned subsidiaries to compete in each other's market. These new subsidiaries would be regulated in the same way as existing banks or brokerages and would be required to hold relations with its parent at arm's length. In addition, to avoid "overcompetition" and give less competitive firms a chance to adjust to new rivals MOF staggered permission for these cross-barrier subsidiary openings. Trust banks first were allowed to open securities operations; some major commercial banks then were given the green light to begin trust management businesses; and, most recently, top securities houses were allowed to open trust banking subsidiaries.
The timing for allowing the plunge into the new markets hardly could have been worse. The new subsidiaries debuted in a hostile business environment: a prolonged domestic recession, plunging prices for Japanese equities, record low interest rates, deregulation of some fees and commissions, and more competition from foreign firms at home and abroad. As the bad-loan crisis has unfolded, the wisdom of allowing parent firms to dilute their capital bases by establishing separately capitalized subsidiaries is becoming less clear. Nevertheless, the top firms in each field were eager to begin building a customer base and gaining experience in the new businesses.
Of the three groups of new subsidiaries the bank-affiliated securities houses seem to have achieved the greatest success to date. Under MOF's stepwise approach to allowing interindustry competition the bank affiliates were restricted to underwriting and dealing in bonds; this meant that stock trading remained the preserve of preexisting securities houses. As predicted by industry analysts, the six bank-affiliated brokerages have traded on the long-standing corporate relationships developed by their parent companies to grab a substantial share of the domestic bond market. After they opened their doors in late 1993, the bank-associated securities units' share of all straight bond flotations climbed from 2.7 percent at the end of FY 1993 in March 1994 to 9.8 percent in FY 1994 and a surprising 22.3 percent as of the end of September 1995.11 In fact, IBJ Securities Co., Ltd. a unit of Industrial Bank of Japan has become the fifth-largest underwriter of straight bonds in Japan in less than three years. These gains have come equally at the expense of Japan's top four brokerage houses and second-tier securities firms. The Big Four Nomura Securities Co., Ltd., Daiwa Securities Co., Ltd., Nikko Securities Co., Ltd. and Yamaichi Securities Co., Ltd. have watched their dominance of the bond market shrink from 67.6 percent in FY 1993 to 57.6 percent in the first half of FY 1995. Smaller brokers have suffered similarly; their share of straight bond issues dropped from 29.8 percent to 20.1 percent over the same time period. The bank-affiliated units' efforts to enter other areas of the bond market, including convertible and warrant bonds, have been less successful so far. Furthermore, it is not clear when MOF intends to give these subsidiaries the right to underwrite and trade stocks. Second-tier brokerages, already suffering from weak investor activity, likely would be hurt the most by such a change.
The trust banking operations of securities firms, in contrast, still are struggling to build a solid client base. While most of the seven subsidiaries had projected that FY 1996 would be their first profitable year since initiating operations in 1993 and 1994, this is looking less likely. MOF's planned deregulation of the trust fund management business (see below) will put even greater pressure on these struggling units. With their parent firms constrained by weak profits from stock market activities, these units may find themselves uncomfortably alone in facing the new tougher competitive environment.
In line with its self-appointed mission to ensure Japan's financial stability MOF has kept a tight rein on the nation's insurance firms. The Japanese market is divided into three segments life, nonlife (property and casualty) and other types of insurance, such as travel and medical. Rigorous rules address maintenance of financial reserves, disposition of investment assets, minimum returns to policyholders from some types of insurance and introduction of new types of insurance policies. Due to high capital and other entry requirements, foreign firms have focused their efforts on the so-called third sector by offering such specialized products as cancer insurance. Because third-sector policies can be more risk-prone than life or nonlife coverage, MOF has been reluctant to allow domestic life and nonlife firms to move aggressively into that market.
Like other financial sectors, the insurance industry has been hard hit by the bursting of the "bubble economy," the prolonged domestic economic recession and, especially, the poor performance of Japanese stock markets, where insurers have invested a significant share of their portfolios. Life insurance firms in particular are suffering. Most have been unable to pay their guaranteed minimum returns on policies out of investment portfolio earnings since 1991. In FY 1994, for example, Dai-Ichi Mutual Life Insurance Co. showed a return on assets of just over 2.9 percent but was committed to policyholders for about a 5 percent return. During the bubble years life insurers had to offer guaranteed returns of as high as 6.25 percent to sell new policies. Insurers then lent the income from policyholders for real estate and stock speculation; that generated one cause of their current woes since property and stock prices have plummeted from their late 1980s' highs, turning these loans into nonperforming assets. Japanese analysts estimate that life insurance companies are saddled with about ¥500 billion ($5 billion) in bad loans. Some life insurers have announced plans to write off the nonperforming loans over several years.
Despite clear signs that stock and land prices had begun deflating rapidly beginning in 1990 (thus eroding and imperiling their investments), life insurers continued to offer policies with relatively high guaranteed returns until 1994. Regulators stepped in that year, imposing requirements designed to ensure that insurers had enough cash on hand to pay the guaranteed returns; officials also cut the guaranteed return from 5.5 percent to 4.5 percent. (Life insurers have announced that they will lower their guaranteed return to 2.5 percent for FY 1996.) These changes forced life insurance companies to rearrange their portfolios in favor of less risky instruments. Risky assets stocks and foreign currency-denominated instruments accounted in FY 1990 for 52.3 percent of life insurers' total assets of ¥130 trillion ($1.3 trillion), but for the six months through September 30, 1995 the ratio came to only 32.8 percent of ¥181 trillion ($1.8 trillion) in total assets.12 The respective figures for safer assets bonds, loans and cash were 44.2 percent in FY 1990 and 64.4 percent for the first half of FY 1995. While this may appear to be a favorable, safe trend, some Japanese analysts warn that it could be the beginning of a vicious circle. Life insurers have been selling stocks not only to raise cash to pay policyholders their guaranteed dividends but to reduce risky assets as well. This selling has added to downward pressure on stock prices and further shrunk life insurers' asset bases. Shifting assets into less risky bonds also causes cash flow problems because returns on Japanese government bonds the preferred type of bond are less than that needed to pay guaranteed earnings. By one estimate life insurers will need to earn 3.6 percent on bonds in FY 1996 to meet their mandatory, promised outlays, well above the 3 percent return currently available on 10-year Japanese government bonds.13
The relatively poor recent performance of insurance companies the average dividend was cut for the fifth consecutive year in FY 1994 has put them on the spot with customers and regulators. About 1.2 million holders of variable life insurance policies facing unbearably high current financial burdens are organizing to force issuers to refund those premiums paid in advance and to rewrite the contracts. Variable life insurance policies were created in the late 1980s and bought, in the view of policyholders, as a way to prepare for high inheritance taxes that naturally were expected due to the skyrocketing values for homes and investment assets during the bubble economy. Unlike ordinary life insurance policies, which offer a minimum return guaranteed by the issuer, these policies offered returns pegged to investment performance, with the risk of variability born entirely by the policyholder. Because the one-shot premiums were at least ¥10 million ($100,000), customers were asked to mortgage their real estate or other assets. Since property and stock prices have tumbled from their late 1980s' highs, variable insurance holders now have policies that earn a measly return coupled with large loans based on assets whose current value is far less than the loan amount. Some policyholders have sued the insurance company or the bank that sold them the policy or the mortgage, but few suits have prevailed. Some policyholders reportedly have committed suicide as one way to solve their debt problems. The overall situation has insurers in a quandary.
Adding to insurers' concerns, the government-affiliated Pension Welfare Service Public Corp. has floated the possibility that it will withdraw the ¥5 trillion ($50 billion) worth of pension funds it has entrusted to 18 insurance companies in light of the imminent fall in the guaranteed investment return to 2.5 percent. The announcement by the affiliate of the Ministry of Health and Welfare rocked the insurance industry and the stock market, since insurers likely would sell shares to raise the sizable cash pullout. Partly in response to these troublesome conditions, but mostly by coincidence, the industry is about to undergo significant changes.
MOF is taking a two-pronged approach to insurance industry reform: allowing competition by companies in different sectors and easing regulations to increase management's flexibility without threatening financial stability. The vehicle for the initial thrust is the new Insurance Business Law, the first major overhaul of the regulatory environment in more than 50 years. Approved May 31, 1995 by the Diet, it will come into force April 1. When the revised law becomes effective, life and nonlife insurance firms will be permitted to enter the other's market via wholly owned subsidiaries. At the moment nonlife insurers seem more eager to take the competitive plunge. Four of the five major property and casualty insurance companies Tokio Marine & Fire Insurance Co., Ltd., Mitsui Marine & Fire Insurance Co., Ltd., Sumitomo Marine & Fire Insurance Co., Ltd. and Nippon Fire & Marine Insurance Co., Ltd. are preparing to establish life insurance subsidiaries. The fifth major nonlife insurer Yasuda Fire & Marine Insurance Co., Ltd. is being more cautious, announcing only that it is developing, in cooperation with Mitsui Marine & Fire, Nippon Fire & Marine and Sumitomo Marine & Fire, a joint computer system to handle life insurance operations. In contrast, only two of the top eight life insurance companies Nippon Life Insurance Co. and Dai-Ichi Mutual Life Insurance are planning to enter the nonlife field.14 The main obstacle to establishing a subsidiary in a new field is the initial capital requirement; smaller insurance firms cannot afford this outlay nor can firms weakened by several years of declining profits.
Deregulation of the third sector is controversial because it will have a disproportionate impact on foreign insurance companies in Japan. As part of the talks under the U.S.-Japan Framework for a New Economic Partnership, Tokyo agreed not to make "any radical change" in the business environment affecting the third sector until "meaningful and substantial" liberalization occurs in the life and the nonlife markets (see JEI Report No. 38B, October 7, 1994). The Clinton administration believed it had an informal understanding with Japan that it would wait three years before allowing subsidiaries of life and nonlife insurers to enter the third sector. This would give foreign firms a chance to break into the fields where Japan's large domestic insurers have built entrenched, long-term ties with clients. U.S. Trade Representative Mickey Kantor maintains, however, that MOF has been sending ambiguous messages to Washington about how it plans to proceed with liberalization. As a result, the U.S. government is attempting to clarify rumors that MOF is going back to its original plan to start the liberalization process with the third sector in short, to ignore the provisions of the framework insurance pact. "We've had a number of responses from Japanese officials, many of them contradictory," Mr. Kantor told reporters in early February. With the April 1 implementation date fast approaching, this issue could rise quickly to the top of the bilateral agenda if MOF does not clarify its plans to Washington's liking.
MOF regulations implementing the new Insurance Business Law likely will give insurers greater freedom to introduce new products and to adjust premiums and payouts to market conditions, another thrust of the October 1994 framework insurance agreement. Nonlife insurers already have found an eager market for product liability insurance since Japan's product liability law went into effect July 1, 1995. Related changes in the fund management market (see below) also could add to insurance firms' flexibility, although greater competition for pension management business is the accompanying price.
At the same time the law will require insurers to report how they measure up to a new standard of financial health. Beginning April 1 a solvency-margin ratio will be required reporting; the calculation involves dividing reserves, capital and latent profits by a risk factor. Since the implementing regulations still are being drafted, MOF has not disclosed what risk values will be assigned to various factors; consequently, the industry is in the dark about the new measurements.
The new law additionally will allow the industry to create a fund to handle the bankruptcy of an insurer. The Life Insurance Association of Japan will manage the emergency fund for its members, while the Marine and Fire Insurance Association of Japan will do the same for the nonlife sector. According to Japanese press reports, the strategy first calls for healthy insurance companies to take over the bankrupt firm's obligations; then emergency funds will be made available to assist in the cleanup process. The life insurance fund will contribute up to ¥200 billion ($2 billion) per failure and the nonlife insurance fund up to ¥30 billion ($300 million) per case.15 Insurance industry watchers fear that the funds are too small, pointing out that the reserve could be drained by the failures of a few medium-sized companies. Moreover, there is no structure to ensure that the fund is replenished once it is tapped. In contrast, the Deposit Insurance Corp., set up to cover bank failures, is funded by member premiums and can borrow from the Bank of Japan in an emergency. If the 4.4 percent increase in cancellations and nonrenewals of life insurance policies in FY 1994 is any indication outstripping the 3.6 percent growth of premium revenues then assuaging public concerns about the stability of insurance firms is not wasted effort.16
After years of reform and liberalization in banking and securities markets, the insurance market is having its time in the limelight. Because of the industry's current poor financial performance and questionable profit outlook, this limelight may not be welcome. Nevertheless, changes in the industry as well as the responses elicited from insurers and regulators are clear evidence of the far-reaching aftershocks of the deflation of the bubble economy.
Although Japan's insurance industry is under a tightly regulated rein, the Finance Ministry keeps an even tighter grip on the reins and the traces of trust and pension fund management vehicles. Until recently MOF and the Ministry of Health and Welfare, which is responsible for government pension funds and government-sponsored funds for private-sector workers, put a premium on security and safety in their pension management decisions. Only a select circle of Japanese trust banks and big insurance companies were permitted to manage pension fund investments. Moreover, fund managers were subject to strict rules as to how they could distribute portfolio assets. The so-called 5-3-3-2 rule set ceilings on the share of each portfolio that could be held in bonds or cash (50 percent), domestic securities (30 percent), foreign securities (30 percent) and real estate (20 percent). Not only did this emphasis on security limit business opportunities for domestic and foreign fund managers outside the select circle, but the restrictions often sacrificed a better rate of return in exchange for a guaranteed minimum.
Regulations also made difficult any direct comparisons of the performance of Japanese fund managers with foreign counterparts because portfolio assets were stated at purchased value, not current market value, as is done in the United States and Europe. As long as investment managers produced the promised minimum return, MOF and MHW had few reasons to tinker with the system. Moreover, when Japan's economy was growing rapidly and its senior citizen population comprised a relatively small percentage of the whole, the risk-averse strategy sufficed. In recent years, however, MOF and MHW officials in charge of pension management have become increasingly concerned that returns on investments were declining just as the number of retired persons was beginning to expand significantly. MHW officials, in particular, began to favor more flexible rules that would allow them to diversify the management of their portfolios and accept greater risk in return for higher earnings. The Finance Ministry, however, remains opposed to a major revamping of the system because it derives significant benefits from the current configuration. The Fiscal Investment and Loan Program, a second capital budget under MOF's control, is funded in large part by government pension monies (see JEI Report No. 32A, August 27, 1993). In theory, the pension funds are invested in construction bonds issued by various FILP agencies; therefore, repayment eventually will be made with interest. In practice, however, it is not clear whether such full repayment takes place; the debt simply may be rolled over on a regular basis. Of equal concern, it is unlikely that the interest rate is competitive with the returns that could be earned elsewhere.
Under strong pressure from the administration of then President George Bush MOF implemented the first significant regulatory change in the industry by allowing investment advisory firms to manage up to one-third of all new private pension monies collected, beginning in 1990. This move opened about 3 percent of the total market to foreign firms, but they were able to garner only about 1 percent of the market by 1993. That year, as part of its effort to push the Uruguay Round of multilateral trade talks toward completion, Tokyo offered to widen investment advisers' access to the market by allowing them to manage funds collected before 1990. This move gave investment advisers a potential opening to about 13 percent of the total market (see JEI Report No. 24B, July 2, 1993).
The next regulatory changes came again under American pressure. One result of the framework talks was a January 1995 agreement that included several points relating to fund management. Investment management firms would not be held to the 5-3-3-2 rule (although at that point trust banks and insurance companies still had to follow the rule); current market value accounting practices would be adopted by all fund managers beginning in 1997; and public pension repositories would be free to place some of their assets with investment management firms (see JEI Report No. 21A, June 9, 1995). In early February MOF announced that the 5-3-3-2 rule would be eased for trust banks. It also said that the ceiling on the share of any one pension fund managed by an investment advisory company would be raised from one-third to one-half April 1 and then lifted totally three years later. Additionally, life insurance firms no longer would be required to set a guaranteed minimum return on pension assets under their management (see JEI Report No. 6B, February 16, 1996).
While these regulatory changes have shaken up a traditionally sedate market, actions by the MHW-affiliated Pension Welfare Service or Nempuku really have made people sit up and take notice. Nempuku officials announced in mid-January that they were taking advantage of the liberties granted by the framework financial services pact to withdraw as much as ¥5 trillion ($50 billion) from accounts held with insurance companies rather than accept insurers' decision to cut the guaranteed return from 4.5 percent to 2.5 percent for FY 1996. True to its word, the giant pension administrator broke sharply with tradition by announcing in late January its decision to place ¥90 billion ($900 million) with three investment advisory firms, beginning April 1. Following procedures unusual for Japan but ordinary in the United States and Europe, Nempuku held competitive meetings with 10 domestic and foreign investment management firms and selected Goldman Sachs Asset Management Japan Ltd., Morgan Stanley Asset & Investment Trust Management Co., Ltd. and IBJ NW Asset Management Co., Ltd. The two American firms are partnered with Nippon Trust Bank, Ltd., while IBJ NW linked with Mitsui Trust & Banking Co., Ltd. in its successful bid for Nempuku's business. The pension overseer's decision could encourage other pension administrators to be more daring, but since no other pension fund has pockets as deep as the MHW affiliate ¥23 trillion ($230 billion) in assets as of the end of FY 1994 the giant fiduciary more easily can afford to risk billions of yen on this kind of experiment.
Investment advisory firms also have been able to capitalize indirectly on Daiwa Bank's recent trouble with its two U.S. operations one that handles commercial banking and another that is in the trust business. A New York City-based Japanese employee at the American bank subsidiary has pleaded guilty to crimes associated with his concealment of $1.1 billion in trading losses over an 11-year period; his actions included making over 30,000 unauthorized transactions, including the sale of customers' securities held by the bank. American employees of Daiwa Bank Trust also stand accused of hiding nearly $100 million in losses during the mid-1980s. Daiwa Bank's failure to detect the losses and its tardy report to U.S. monetary authorities after it did finally learn of the illegal activity resulted in federal action to close its U.S. operations (see JEI Report No. 42B, November 10, 1995). Using the Daiwa Bank woes as a cautionary tale, investment advisory firms, particularly foreign ones, have been emphasizing to Japanese clients their strict internal controls and thorough disclosure standards, both of which contrast sharply with the traditional practice of Japanese trust banks and insurance firms.
Potential problems and issues remain to be addressed by the fund management industry and the government before the level of competition could be characterized as freewheeling. Stock market analysts are fearful that the shift of pension funds away from insurance firms will depress share prices as the insurers liquidate holdings to return funds to clients. When Nempuku announced that it was thinking of switching ¥5 trillion ($50 billion) from insurers to investment advisory firms, traders on the Tokyo Stock Exchange were shaken. Another issue is that corporate pension fund administrators may hesitate to take advantage of the new freedoms because traditional pension fund managers trust banks and insurance companies often are linked by cross-shareholding ties and may retaliate against those companies that decide to shift assets away from them by dumping their sizable stock holdings and driving down the prices of those shares. The withdrawal of pension funds from trust banks and insurers directly hurts these already struggling institutions. If the shift of funds away from these traditional managers is rapid and large, it likely will hurt their performance, at least in the short term. Nevertheless, domestic and foreign fund management companies are excited about the changes and are beefing up their staffs.
With buying sentiment still weak among stock investors and with domestic interest rates at record-low levels, Japanese and foreign firms not surprisingly have been rushing to issue bonds in Japan. For firms with solid credit ratings the cost of raising funds via bonds (2.2 percent to 2.5 percent) currently is less than the cost of a bank loan (2.8 percent). The bad-loan situation also has led banks' loan officers to be much more selective and cautious in analyzing potential borrowers, further increasing bonds' attractiveness. The bond stampede has been aided by Finance Ministry actions designed to ease issuing requirements and improve bond market structures. A negative factor, however, is that Japan's bond markets still lack a secondary market; investors generally hold bonds until they mature. This makes the market much less liquid and attractive than the stock market or foreign bond markets. With the borrowing needs of the Japanese government projected to begin rising sharply as efforts to boost the economy and meet the demands of a graying population increase, a smoothly functioning and deep bond market is more important than ever.
Two MOF changes have made it easier for companies to seek financing directly from investors. Shelf registration of bonds a procedure implemented in July 1995 that allows an issuer to obtain preapproval for a bond flotation without setting a specific issue date provides companies more issuing flexibility. Registering bonds but putting them on the "shelf" in reserve instead of immediately selling them lets firms move quickly to take advantage of favorable market conditions. This new flexibility plus low domestic interest rates breathed new life into the Japanese market for yen-denominated bonds issued by foreign entities, so-called samurai bonds. The shelf-registration procedure helped boost straight corporate bond issues to a record ¥5 trillion ($50 billion) in 1995, topping the prior record of ¥3.7 trillion ($37 billion) set in 1993.
MOF's latest move, effected this January, greatly eases the qualifications for corporations wishing to issue bonds. The new rules abolish the minimum BBB credit rating required to issue bonds, meaning that both unlisted and unprofitable firms are eligible to float the instruments. This move was aimed at giving new ventures in emerging industries another way to raise capital. The Finance Ministry also has dropped a requirement that forced companies issuing bonds to hire a trustee/administrator, a role usually filled by banks for a substantial fee. For example, Softbank Corp. saved ¥200 million ($2 million) in bond flotation costs by not hiring a trustee/administrator to oversee the handling of its ¥50 billion ($500 million) bond issue last September.17 Major firms, such as Japan Airlines Co., Ltd. and Mitsubishi Electric Corp., have followed Softbank's example.
Matching this surge in the supply of bonds has been a rise in the demand for them. Insurers, trust banks and other long-term investors have snapped up most bond issues in their search for more secure investments and stable yields. Bonds look very attractive in current circumstances compared to stocks and overseas assets (which are subject to exchange rate fluctuations).
Effective action by MOF to develop an active secondary market for corporate bonds would spur demand to even higher levels. Although the ministry began permitting qualified companies to act as "market makers" in the secondary market in 1993 buying and selling bonds when there are unmatched buy or sell orders this has had little impact on Japanese investors' tendency to hold bonds until maturity. An MOF advisory body studying the situation has offered some suggestions, such as creating tax incentives to trade bonds, but these options are not viable given the current tight government budget.
On top of the increasing supply of corporate bonds is an expected glut of government bond issues. In its latest midterm fiscal projection MOF indicated that annual issues of general revenue bonds, which fund current operations, may rise from ¥2.9 trillion ($29 billion) in FY 1995 to almost ¥12 trillion ($120 billion) in FY 1996 and then to nearly ¥16.2 trillion ($162 billion) by FY 2000. Total outstanding government bonds will balloon from an expected ¥240.5 trillion ($2.4 trillion) in March 1997 to ¥301.1 trillion ($3 trillion) by April 2000. With signs that economic growth is reviving and that interest rates will begin to rise from record-low levels, prices in the secondary market for government bonds are expected to come under pressure.
One change that is expected to take effect April 1 is the creation of a repurchase agreement market for government bonds. In a repo agreement a bondholder (often a bank) lends the bond to another party in exchange for cash and with the agreement that the original holder will buy back the bond in the future at an agreed-upon price that usually includes a profit for the other party. In other words, a repo lets the bondholder turn that asset into cash for a set period of time while earning the cash-provider a profit. At present banks and other owners of large amounts of government bonds generally use the secured call market to convert their bonds temporarily into cash when needed. The repo market is expected by experts to prosper, especially since MOF last September lifted a restriction on the interest rates that could be charged for cash loans (which underpin the repo agreement). The repo market for government bonds could grow to an outstanding balance of ¥20 trillion ($200 billion) soon after it opens, according to these pundits. Such a development would help the private sector digest the huge helpings of debt that Tokyo expects to serve up.18
Japanese equity prices at last may have found their "legs." In mid-1995 the Nikkei average of 225 shares traded on the first section of the Tokyo Stock Exchange sank to a one-day closing low of 14,485.41 or 26.6 percent below its 1995 starting point. By the end of the year, however, the Nikkei 225 had recovered sufficiently to eke out a 0.7 percent gain for the whole year and a 37.2 percent rebound from its 1995 low (see JEI Report No. 2B, January 19, 1996). With recent trading solidly in the 20,000 range for the indicator, many market analysts are convinced that investors at last are shaking off the pessimism that has gripped the market since 1990. If the nonperforming/underperforming loan problem is not resolved and more financial institutions fail, however, these weak glimmerings of investor optimism may be snuffed out.
A Once-Troubled Exchange and Efforts to Reform - Stock trading value and volume on the TSE have remained far below the heydays of the late 1980s. It is dawning on brokers and analysts, however, that using the bubble economy years as the yardstick to measure the health of the market may be unjustifiable. Since stock prices began to plunge in 1990, stock exchange, brokerage and MOF officials have searched for ways to pump up trading volume and share prices but to little avail. Scandals involving questionable trading practices by top securities houses and the failure of some key shares to retain their initial value such as those of the former government monopoly Nippon Telegraph and Telephone Corp. destroyed small investors' confidence that TSE trading operated on a fair and objective basis. As the bad-loan situation developed, financial and nonfinancial firms have been forced to realize the latent profits in their stock investment portfolios, subjecting the market to constant and heavy selling pressures. Even reforms designed to help the market have been met with skepticism, including corporate suspicion of government rules changes to make stock buybacks more attractive. Deregulation of some trading rules in mid-1995, such as self-imposed limits on major brokers and limits on margin transactions, did help draw some investors back to the market and allowed brokers to cushion downward price moves.
In other areas of reform TSE officials have been trying to address issues pertaining to the structure and the operation of the exchange. A top concern has been the steady decline in the number of foreign firms listed on the TSE. Foreign firms whose shares were listed on the TSE numbered 93 at the end of 1994; this figure had dropped to 77 by this February. In addition, between 1993 and just recently no new foreign firms sought to be listed. Claiming that the costs of continuing to offer their shares in Japan far outweigh the benefits, major American and European firms have been pulling out. TSE officials, who have waged a long campaign to make the exchange an international market, have seen many of their gains evaporate. Efforts to counter this decline have proceeded along two paths. The exchange has initiated a program to attract fast-growing Asian firms to list their shares on the TSE. This campaign paid its first dividend in early February when YTL Corp., a Malaysian holding company, listed its shares. The second counterpunch is meant to ease the way for venture enterprises to list their shares on the second section of the TSE. This move partly parries the popularity of Japan's over-the-counter market but also represents the TSE's first serious effort to attract companies that could be leaders of future industries, such as multimedia.
The depressed state of the stock market has put the exchange in a tight fiscal spot. After running deficits for three consecutive years, beginning with FY 1990, the TSE eked out small profits in FY 1993 and FY 1994. In working toward a balanced budget for FY 1996 the exchange is gauging members' attitudes toward a membership fee increase. Smaller brokerage firms, most of which likely will report another year of losses in FY 1995, probably will resist any increase. Instead, they even may ask the TSE to cut its costs (primarily what they see as high salaries) before asking members to pony up.19
A recent development that could help revive the securities industry is MOF's pledge to allow many more types of asset-backed securities to be offered for sale. Under current rules the right to receive the interest earned on assets, such as a mortgage loan, can be sold like a security, but each security can be based only on one asset. If that one asset falls in value or the mortgage borrower defaults, the security becomes of questionable value. As part of a recent agreement with the Clinton administration, MOF will allow assets to be pooled and the rights to the returns from these assets to be divided into smaller units (see JEI Report No. 6B, February 16, 1996). This will bring the Japanese situation much closer to that in the United States. Companies with large real estate, loan or leasing contracts are eager to take advantage of the upcoming liberalization, meaning that an entire new class of securities will be created for brokers to underwrite and trade. In addition, the shift will help banks saddled with nonperforming or poorly performing loans, as they can package these assets and try to recover some of their value.
Impact of Bad-Loan Crisis on Equities - The bad-loan crisis has stimulated shareholder rights interest in Japan. Owners of shares in failed or troubled financial institutions, such as Cosmo Credit, Hyogo Bank, the seven jusen companies and Daiwa Bank, have or are considering filing lawsuits against company executives for breach of fiduciary duty. Some corporate leaders are beginning to complain about nuisance suits by shareholders20 a refrain familiar to many American counterparts.
Even more striking, it is becoming less unusual for shareholders to disagree with management and for them even to press management to change corporate direction. In one unusually public battle East Japan Railway Co., Ltd. is trying to force Japan Travel Bureau Inc. to be more aggressive about turning a profit. JR East holds 21.9 percent of JTB's stock and is urging JTB management in public forums to boost the value of the tour planner and ticket seller's shares.21
Even as the nonperforming/underperforming loan troubles were heating up, the February 1995 collapse of a respected English investment bank, Barings PLC, left a mark on Japanese trading of instruments derived from stocks, commodities, exchange rates, interest rates and other financial assets. The huge losses accumulated by a Barings employee who had made wrong bets on derivatives contracts was a warning flag to monetary authorities around the globe (see JEI Report No. 9B, March 10, 1995). Besides examining the impact on the Osaka Stock Exchange where the Barings trader placed his ill-fated contracts, Japanese authorities began investigating the derivatives trading activities of domestic institutions. It was revealed in July 1995 that Japanese banks which, some say, pushed to seek even risky profits to deal with their bad loans were engaged deeply in derivatives trading. In mid-1995 derivatives contracts held by Japan's top 11 nationwide commercial banks totaled ¥731.2 trillion ($7.3 trillion), 1.7 times their total assets. Some banks were even more exposed to derivatives' risk. The value of Bank of Tokyo's derivatives portfolio was 4.1 times its assets, a position justified by BOT officials on the grounds that it is wise to hedge the bank's many foreign exchange dealings.22
A late 1995 survey by the Basel, Switzerland-based Bank for International Settlements showed that Japan had become one of the largest markets for derivatives trading. Japan's over-the-counter market was the third-largest global market for derivatives trading, with a daily volume of just under $1.4 billion generating a gross market value of $621.3 billion; that compared with a global gross market value for derivatives of $1.7 trillion. The relative lack of sophistication of Japanese firms compared to foreign firms with regard to derivatives also is clear. About a dozen foreign firms control about 42 percent of all derivatives trades in Japan, while a much larger number of Japanese companies count for a roughly 58 percent share.23 In addition, as of late 1995 Japanese derivatives traders were holding a much larger portion of the balance of contracts (81.8 percent) compared with their foreign-owned counterparts (18.2 percent), meaning that the Japanese firms were bearing most of the risk if a derivative trade proved to be a bad bet. Japanese government officials have encouraged companies that deal in derivatives to announce publicly their total contract volume and risk load. Beyond this, however, policymakers feel that they can only counsel the firms to develop more sophisticated trading and risk management techniques. Japanese monetary authorities have been working with their counterparts in other countries to set international standards for reporting derivatives' risks and to create a safety net in the event of a failure (due to derivatives losses or other causes) of an institution with significant international links.
More sophisticated trading and risk management techniques did not give Japanese multinationals much protection in 1995 from the yen's wide movements against the dollar and other currencies (see JEI Report No. 2B, January 19, 1996). In fact, some firms appear to have outsmarted themselves when they hedged aggressively and the yen subsequently moved sharply in the direction opposite to their expectations, leading to large losses. Currency traders at some Japanese firms have given up trying to make longer term predictions about the yen's value and have adopted a defensive strategy, limiting their exposure to unexpected medium-term exchange rate swings by hedging with a very short time horizon.
For its part the Ministry of Finance has been pulling strings to keep the yen from rising to the record levels achieved during the first half of 1995. In a move that surprised the market the Finance Ministry announced in early August 1995 a deregulation package aimed at encouraging Japanese purchases of foreign assets. The measures included: allowing insurance firms to extend foreign-currency loans, lifting the 50 percent ceiling on insurance companies' participation in overseas yen-loan syndicates, dropping the 90-day waiting period that prevented Euroyen bonds floated by nonresidents from being sold in Japan immediately after issue, and encouraging government financial institutions to increase overseas lending.24 In October MOF began allowing investors to deposit more than ¥100 million ($1 million) in overseas foreign currency accounts without first getting the ministry's approval. Through this move MOF hopes to make it easier for investors to take advantage of higher overseas interest rates for deposits. The Finance Ministry also eased rules that had restricted investment trusts targeting overseas instruments from sinking more than 49 percent of their assets in Euroyen bonds. This loosening recognized that investors could shield themselves from foreign exchange risks while still putting money into foreign instruments.
At the end of January the ministry further loosened its grip in deciding to: allow Japanese companies to make foreign exchange deals directly with overseas banks rather than through an overseas subsidiary; ease rules governing the settlement of foreign currency-denominated transactions between Japanese companies; and drop the reporting requirement when a domestic company makes a loan to an overseas firm.25 These steps are intended to increase competition among foreign exchange banks for Japanese business, potentially leading to lower fees or rates and, therefore, more activity. They also are aimed at reducing the need for domestic firms to convert yen into foreign currencies to settle transactions with foreign business partners. Moreover, the changes could help to shield firms from unexpected swings in the yen's value.
As the volume of foreign exchange dealing grows not only in Japan but in the rest of Asia, Japanese monetary authorities are becoming concerned about the potential for rapid and destabilizing shifts by investors into or out of a currency or a market. Observers attribute at least some of Mexico's recent economic difficulties to the rapid flight of capital from Mexican markets in the wake of the peso's sharp fall against the dollar in late 1994. Some Japanese officials are worried that a similar capital flight could shake their part of the world. Asian monetary authorities quietly have been discussing the creation of a regional version of the Bank for International Settlements that would help Asian central banks monitor financial activities in the area and coordinate actions. Hong Kong, Malaysia, Thailand and Indonesia signed an agreement last November to create a joint pool of U.S. Treasury bonds to serve as a source of funds should there be a sudden need for foreign exchange to meet a crisis.26 While Japanese officials are receptive to the idea of creating a safety net to guard against large, speculation-induced swings in exchange rates, it is less keen on the idea of an Asian BIS. In part this is because the International Monetary Fund will offer plans by this spring to create an emergency loan facility to handle foreign currency crises like the Mexican debacle.
The real estate market has not garnered concerted attention from Japanese policymakers or the financial community, despite the fact that restoring this market to health would ease many problems, including the nonperforming/underperforming loan crisis. Real estate is the collateral base for many Japanese loans, especially those made during the bubble economy years. As part of their plan to cap the late 1980s' speculative boom, MOF and the Bank of Japan discouraged new lending for real estate transactions, starting in April 1990 (see JEI Report No. 2A, January 19, 1996). Their plan worked too well, however. Property values plunged about 50 percent between 1991 and 1995, although there are now some signs that the market has hit bottom. Reforming the property market, however, is a Gordian knot because so many ministries are involved, sometimes with conflicting policies. Land-holding taxes, for example, are used to preserve agricultural properties but thwart commercial development. Reform also pits beneficiaries (like MOF) against those who bear the burden of inheritance taxes and capital gains taxes or receive agricultural subsidies. In addition, complex social issues are involved, such as urban overcrowding, the potential involvement by organized crime, the disparities between rural and urban job potentials and the quality of life in nonurban versus metropolitan areas.
Tokyo has tried several times since 1991 to revitalize the real estate market but with little result. As part of several fiscal stimulus packages assembled by various cabinets, funds have been allocated to local governments for the purchase of land for parks or other uses. In mid-1995 the Japanese media reported that the ruling coalition was considering taking this approach one step farther by creating a government-funded organization that would buy and sell land like a commercial enterprise.27 One obvious task for this new group would be to buy the property that underlies many of the nonperforming loans burdening Japanese financial institutions. Because such an activity would be another form of publicly funded bailout of financial institutions, it likely would be as unpopular with the Japanese voting public as is the current government plan to use tax monies to assist the liquidation of the jusen.
A change that might have more chance of impacting positively the stagnant property market is MOF's decision to allow assets to be converted into securities in a fashion similar to what is done in the United States (see JEI Report No. 6B, February 16, 1996). By bundling mortgages or other loans into a pool and then selling shares of the pool to investors, the risk to investors of any one borrower defaulting and hurting the value of their security becomes much smaller. Bundling assets together also can improve the salability of the assets compared with their individual marketability.
The latest government plan that might have the side effect of helping to enliven the property market is the Ministry of Transport's drive to bring into solvency JNR Settlement Corp. the inheritor of many of the debts and idle assets of the Japanese National Railways. JNR Settlement was given 10 years, until the end of FY 1997, to retire the former government monopoly's debts; any remaining debts then would be borne by the government. But plans have gone awry, and JNR Settlement's debts are expected to reach ¥28 trillion ($280 billion) by the end of FY 1995. Some analysts estimate that the government (and taxpayers) will face as much as ¥20 trillion ($200 billion) in unretired JNR debts at the start of FY 1998. The Transport Ministry understandably is anxious for JNR Settlement to accelerate the sale of its land and stock assets to pay off as much debt as possible. To add further fuel to the fire though in a roundabout way MOT is considering easing the formulas used to set rail fares because these requirements now discourage railway companies from showing too high a profit. The reasoning is that railroads have no incentive to sell off some of their large and choicely located property (mostly along their rail lines) because to do so would boost their profits and make them less likely to receive permission to increase fares. Breaking the link between profits and fare hikes may encourage these big landholders to begin unloading some assets and so spur the market. Whether this plan will pan out as expected is unclear; the rail companies may decide to develop the property themselves rather than sell it, or simply not sell. In any case these efforts do not address the many underlying issues that must be cleared up before Japan's real estate market can function smoothly. What is more important, it appears that MOF is preoccupied at the moment with other matters, such as its own survival in its current form.
Not surprisingly, the Finance Ministry has become everyone's favorite "whipping boy," as the bad-loan crisis has unfolded and problems have cropped up in other financial areas. Because of the ministry's comprehensive powers, close ties with the firms it regulates and the employment of retired MOF officials at many troubled firms, many analysts are incredulous that the ministry would have no idea of the ill-advised and sometimes legally questionable activities that led to the current crisis. Moreover, MOF has been accused of helping to cover up the problems and of standing in the way of a quicker resolution. Sentiment in favor of reforming and restructuring MOF has snowballed in recent months, but it still is not clear whether changes actually will be made.
Possible restructuring moves include:
1aa Jathon Sapsford, "Japanese Banks Bracing for Bitter Pill," Wall Street Journal, February 20, 1996, p. A11. Return to Text
2aa "Three Major Banks Plan to Cut Workforce," The Japan Times, February 12, 1996, p. 2. Return to Text
3aa "DKB to Cut 2,000 Jobs Over Four Years," The Japan Times, February 7, 1996, p. 9. Return to Text
4aa Tatsuya Inoue, "Banks Prune Personnel, But Costs Stay High," The Nikkei Weekly, January 15, 1996, p. 12. Return to Text
5aa Kaoru Morishita, "Banks Venture Into New Lending," The Nikkei Weekly, July 31, 1995, p. 14. Return to Text
6aa Benjamin Fulford, "Little-Guy Lenders Leave Big Banks Behind," The Nikkei Weekly, September 18, 1995, p. 1+. Return to Text
7aa "Banks' Allure Waning Amid Decontrols: Poll," The Japan Times, November 4, 1995, p. 10. Return to Text
8aa Joshua Ogawa, "Depositors Cite Advantages of Safety, Service," The Nikkei Weekly, July 17, 1995, p. 2. Return to Text
9aa Joshua Ogawa, "¥200 Trillion Flows Into Postal Savings; Cash-Hungry Banks Clamor for Reform," The Nikkei Weekly, July 17, 1995, p. 2. Return to Text
10aa Ogawa (July 17, 1995), op. cit. Return to Text
11aa Masako Fukuda, "Bank-Affiliated Securities Firms Gain Bond-Market Share," The Nikkei Weekly, September 18, 1995, p. 16. Return to Text
12aa Yumiko Suzuki, "Life Insurers Try To Cut Investment Risks," The Nikkei Weekly, February 19, 1996, p. 12. Return to Text
13aa Robert Steiner, "Japan Life Insurers' Cash-Flow Problems Could Cast Pall Over Market's Recovery," Asian Wall Street Journal, January 22, 1996, p. 16. Return to Text
14aa Hideaki Kanazawa, "Japan's Nonlife Insurers Lead Mutual Entry Race," Journal of Commerce, July 25, 1995, p. 7A. Return to Text
15aa Tatsuya Inoue, "Funds To Protect Insurance Policyholders Planned," The Nikkei Weekly, February 12, 1996, p. 12. Return to Text
16aa Masako Fukuda, "Cash-Strapped Clients Dropping Life Insurance Policies," The Nikkei Weekly, August 7, 1995, p. 12. Return to Text
17aa Yumiko Suzuki, "Companies Turn More to Capital Markets," The Nikkei Weekly, February 5, 1996, p. 12. Return to Text
18aa "Warm Welcome Seen for Repo Market Debut," The Japan Times, January 20, 1996, p. 9. Return to Text
19aa Jiji Press, "TSE Finds Itself in a Fiscal Catch-22," The Japan Times, February 16, 1996, p. 9. Return to Text
20aa Takeshi Saito, "Lawsuits by Shareholders Worry Firms," The Japan Times, August 22, 1995, p. 10. Return to Text
21aa Makoto Sato, "Boardroom Battle Heats Up At JTB," The Nikkei Weekly, July 25, 1995, p. 9. Return to Text
22aa "Derivatives Trades Exceed Bank Assets," The Nikkei Weekly, July 3, 1995, p. 19. Return to Text
23aa Masako Fukuda, "Derivatives Market in Japan Big in Volume and Risk," The Nikkei Weekly, December 25, 1995, p. 14. Return to Text
24aa Akira Ikeya, "Surprise Moves Strengthen Dollar, Stocks," The Nikkei Weekly, August 7, 1995, p. 1+. Return to Text
25aa "Curbs on Overseas Loans, Investments to be Eased," The Japan Times, February 1, 1996, p. 11. Return to Text
26aa "Asia Studies Forex Safety Net," The Nikkei Weekly, January 8, 1996, p. 18. Return to Text
27aa Akira Ikeya, "Use Public Money to Activate Realty Market?" The Nikkei Weekly, July 17, 1995, p. 3. Return to Text
28aa Yumiko Suzuki, "Changes Sought for BOJ But Which Way?" The Nikkei Weekly, November 6, 1995, p. 2. Return to Text