JAPAN’S BANKING SYSTEM:FROM THE BUBBLE AND CRISIS TO

RECONSTRUCTION

Masahiro KawaiInstitute of Social Science

University of TokyoJapan

Center for Global Partnership Conference“Macro/Financial Issues and International Economic Relations:

Policy Options for Japan and the United States”Tokyo, May 13, 2004

PRESENTATIONI. INTRODUCTIONII. MACROECONOMIC DEVELOPMENTS

AND THE BANKING SECTOR III. CAUSES OF THE BANKING SECTOR

CRISIS AND DIFFICULTIESIV. IMPACT OF BANKING SECTOR

DISTRESS V. POLICY FRAMEWORKS FOR BANK

RESTRUCTURING AND ITS PROGRESSVI. CONCLUDING REMARKS

I. INTRODUCTION• What are the factors behind the recent banking sector

difficulty, particularly the 1997-98 systemic crisis, in Japan?

• Why did the government fail to address the problem early, quickly and decisively?

• Since the crisis, has the FSA formulated and implemented a comprehensive policy to resolve banking sector problems?

• Has there been sufficient progress on financial sector and corporate sector restructuring?

• Is the worst over in the Japanese banking system? Is the banking sector solvent? What are risks?

• What should be done to transform the Japanese banking system into a competitive market-based system?

II. MACROECONOMIC DEVELOPMENTS AND THE BANKIG SECTOR

1. Macroeconomic Performance and Policy• Output stagnation (Figure 1) : The average annual growth rate

of real GDP was 1.1 percent during the last decade, 1992-2002. Near-zero growth (0.1%) in 1998-2002. In addition, nominal GDP has been more stagnant (-1.2% in 1998-02).

• Price deflation (Figure 2) : The average annual inflation rates during 1992-2002 were low or negative at 0.2% for CPI and -0.1% for GDP price deflators. The GDP deflator fell in 1995-2002 (except 1997) at 1.0% per year and CPI fell in 1999-2002 at 0.7% per year.

• High unemployment rate, reaching a peak of 5.5%. • Keynesian fiscal spending in 1992-2002, rising from the

average size of 32% of GDP in 1991 to 39% in the early 2000s, with a declining fiscal revenue (from 34% of GDP in 1991 to 31% recently).

Figure 1. Japan's Nominal GDP and Real GDP, 1980-2003

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Figure 2. Japan's Price Developments―GDP Deflator, Consumer Price Index (CPI),and Domestic Corporate Goods Price Index (DCGPI), 1980-2003

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GDP Deflator Consumer Price Index Domestic Corporate Goods Price Index

II. MACROECONOMIC DEVELOPMENTS AND THE BANKIG SECTOR (cont’d)

2. Asset Prices• There was an asset price bubble in the late 1980s.

The increases in asset prices were much faster than nominal GDP (Figure 3).

• The equity price reached its peak in December 1989 and has since then declined as a trend.

• The urban land price for six major city areas reached its peak in September 1991 and since then has been declining persistently.

• Relative to nominal GDP (1980=100), the land price became lower in 1996 and the equity price in 2002.

Figure 3. Japan's Asset Prices―Stock and Land Prices―and Nominal GDP, 1980-2003

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1980 1985 1990 1995 2000

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Urban Land Price Index of Six Large City Areas TOPIX Nominal GDP

II. MACROECONOMIC DEVELOPMENTS AND THE BANKIG SECTOR (cont’d)

3. Banking Sector Conditions• Expansion of bank loans in the late 1980s, together with the

expansion of bank deposits (Figure 4). Loans were extended to firms with assets such as land as a collateral.

• Loans were concentrated in wholesale and retail trade, real estate, finance and insurance, and construction (Table 1).

• The bursting of the bubble in the early 1990s made highly indebted firms in these sectors unable to repay due to the decline in collateral values, thus creating non-performing loans (NPLs).

• But bank exposure to certain sectors, such as real estate and construction, continued to expand until the second half or the middle of the 1990s.

• As a result, NPLs rapidly increased in the banking sector, and the banking system fell into a systemic crisis in 1997-98.

Figure 4. Japanese Banks' Deposits and Loans & Discounts, 1980-2003

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1980 1985 1990 1995 2000

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Deposits Loans & Bills Discounted

(b) Percentage DistributionTotal Manufac- Individuals All Other

Loans & turing Total Wholesale & Real Estate Finance & Construction OtherYear Discounts Sector Non-man. Retail Trade Insurance Non-man.1983 100.0 28.3 58.1 -- 7.1 6.2 5.2 -- 10.3 3.31984 100.0 26.6 59.8 -- 7.5 7.3 5.4 -- 9.8 3.81985 100.0 25.2 61.0 -- 8.4 7.9 5.4 -- 9.6 4.21986 100.0 22.7 63.3 -- 10.4 9.1 5.3 -- 10.0 3.91987 100.0 19.7 65.2 -- 11.1 10.6 5.0 -- 11.4 3.71988 100.0 17.9 65.9 -- 11.7 11.1 5.0 -- 12.6 3.51989 100.0 16.0 66.0 -- 12.2 11.2 5.2 -- 15.1 3.01990 100.0 15.0 66.2 -- 11.9 11.1 5.1 -- 16.0 2.81991 100.0 14.9 65.8 -- 12.0 10.5 5.3 -- 16.5 2.81992 100.0 14.6 66.0 -- 12.4 10.2 5.7 -- 16.5 3.01993 100.0 15.6 65.8 15.1 11.7 10.6 6.1 22.2 15.9 2.61994 100.0 15.3 66.2 15.0 12.0 10.8 6.3 22.2 15.9 2.61995 100.0 14.7 66.0 14.6 12.1 10.7 6.3 22.3 16.7 2.71996 100.0 14.3 65.6 14.4 12.4 10.1 6.2 22.5 17.4 2.81997 100.0 13.8 65.3 14.2 12.7 10.0 6.2 22.2 17.8 3.01998 100.0 14.1 64.2 14.3 12.9 9.5 6.4 21.2 18.5 3.11999 100.0 14.8 63.3 14.4 12.6 9.1 6.3 20.9 19.1 2.82000 100.0 14.6 62.4 14.1 12.5 8.8 6.1 20.8 20.2 2.82001 100.0 14.5 60.8 13.7 12.5 8.4 5.9 20.3 21.6 3.02002 100.0 14.1 59.3 13.0 12.3 8.7 5.4 19.9 23.4 3.22003 100.0 13.5 58.3 12.7 12.2 8.4 4.9 20.0 24.9 3.3

Source: Bank of Japan, Financial and Economic Statistics Monthly .

Non-manufacturing Sector

Table 1. Loans and Discounts Outstanding by Sector―All Domestically Licensed Banks

III. CAUSES OF THE BANKING CRISIS1. Overextension of Loans during the Bubble Period Several factors led to loan overextension in the second half of

the 1980s.• Financial liberalization and greater opportunities for risk-

taking: Financial liberalization in the mid-1980s allowed small financial institutions to venture into new areas, particularly funding housing finance companies (Jusen) and other real estate investments.

• Shifts in bank clients to non-manufacturing firms: With large firms increasingly having access to capital markets, major banks began to direct their loans towards non-manufacturing firms, like in real estate, construction and SMEs,

• Unwarranted expectations of high economic growth.• Low interest rate policy.• Weak corporate governance on the part of banks.

III. CAUSES OF THE BANKING CRISIS (cont’d)

2. Severe Negative Impact of Asset Price Deflation• Rapid credit growth had been accompanied by a doubling

of stock prices and a massive rise in commercial estate prices, particularly in major cities.

• A sharp increase in interest rates and the introduction of credit ceiling on bank loans to real estate-related activity led to the bursting of the asset price bubble.

• The bursting of the bubble created substantial losses for firms that held equities and had borrowed from banks with real estate as a collateral.

• This transformed overextended loans into non-performing loans, and the large build-up of capital investment and labor employment during the bubble period into excesses.

• Asset price deflation has continued for more than ten years.

III. CUASES OF THE BANKING CRISIS (Cont’d)

3. Policy Failure to Contain the Problem Quickly• Policymakers initially had a strong bias against the

bubble and continued to suppress asset prices even after the price collapse.

• Hesitation in taking decisive measures for fear that it might touch off a banking sector panic.

• The initial approach was based on the expectation that a resumption of economic growth would restore financial health of banks and their clients.

• Keynesian fiscal policy sustained minimum growth.• There was no domestic or external pressure to accelerate

the resolution of banking problems.

IV. IMPACT OF BANKIG DISTRESS1. Collapse of the Traditional “Convoy System”• Until the 1990s, the process for managing bank failure was largely

ad hoc, based on the informal “convoy system.”• Using its branch licensing authority, MOF encouraged stronger,

healthier banks to absorb insolvent institutions through informal, administratively orchestrated, bank P&A transactions.

• In addition, BOJ often provided liquidity assistance to prevent systemic crises.

• But it became increasingly difficult to persuade banks to provide assistance to other troubled banks because even relatively strong banks faced serious NPL problems.

• Major shareholders and firms associated with Hokkaido Takushoku Bank, Yamaichi Securities and Sanyo Securities refused to help them. Relatively strong banks also refused to provide assistance.

• Temporary nationalization of the Long-Term Credit Bank of Japan in October 1998 signified the end of the “convoy system.”

IV. IMPACT OF BANKIG DISTRESS (cont’d)

2. Downsizing of Bank Business• One response to the banking crisis has been further

deregulation, rather than stopping it, along with the principle of “Financial Big Bang,” and the encouragement of mergers and consolidation.

• The temporarily nationalized LTCB was sold to foreign stakes.

• Commercial banks have been forced to rethink their business strategies by downsizing their operations-End of quantitative targets (maximization of deposit collection and loan extension)-Focus on core competency-Retreat from foreign operations

IV. IMPACT OF BANKIG DISTRESS (cont’d)

3. Impacts on Monetary and Fiscal Policy • Commercial banks with large NPLs have not been expanding

loans, and indebted firms have had no appetite to borrow, and instead have been repaying their bank loans to reduce debt.

• Weaker monetary transmission mechanisms:-Under the zero interest rate policy, BOJ switched to “quantitative easing” (March 2001) providing liquidity to the banking sector. Monetary base has been growing relatively fast, but M2&CD has not been growing as fast (Figure 5).-Absence of banks’ normal financial intermediary function weakens monetary policy transmission mechanisms.

• Fiscal worsening: Rise in government spending, decline in tax revenue, large budget deficits and mounting public debt.

Figure 5. Japan's Money Supply and Bank Loans, 1980－2003

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Monetary Base M2+CD Domestic Bank Loans

V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND ITS PROGRESS

1. Stabilization of the Banking System • The banking sector was in systemic crisis in late 1997 to

1998. The banking sector has been stabilized since then due to more decisive policy actions.

• Means of stabilizing the banking sector:-Blanket deposit guarantee-Extension of emergency liquidity assistance to troubled banks-Financial assistance to promote mergers among troubled financial institutions-Decision to inject capital to weak but viable banks

-Temporary nationalization of non-viable banks

V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND PROGRESS (cont’d)

2. Bank Restructuring • Public recapitalization (March 1998, March 1999, May

2003). See Table 2.• Recognition of NPLs—with tighter loan classification

and loan loss provisioning—helps not only identify the size of NPLs but also prompts faster NPL disposals

• Disposal of bank NPLs, close to 90 trillion yen in the last ten years. Despite disposals, bank NPLs have not declined fast due to the emergence of new NPLs (Table 3).

• Exit of a number of inefficient deposit-taking institutions.• Establishments of public AMCs (RCC, IRC) has

encouraged the carving out of NPLs.

Table 2. Public Capital Injection into the Banking System, March 1998 and

1999 (Billions of yen)

March 1998 March 1999 Banks

Total Preferred Shares

Subord. Debt.(a)

Subord. Loans

Total Preferred Stocks

Subord. Debt

City Banks Tokyo Mitsubishi 100 0 100 0 -- -- -- Daiichi Kangyo 99 99 0 0 900 700 200 Sakura 100 0 100 0 800 800 0 Sumitomo 100 0 100 0 501 501 0 Fuji 100 0 100 0 1,000 800 200 Sanwa 100 0 100 0 700 600 100 Tokai 100 0 0 100 600 600 0 Daiwa 100 0 0 100 408 408 0 Asahi 100 0 0 100 500 400 100

Long-Term Credit Banks Industrial Bank of Japan 100 0 100 0 600 350 250 Long-Term Credit Bank(b) 176.6 130 0 46.6 -- -- -- Nippon Credit Bank(b) 60 60 0 0 -- -- --

Trust Banks Mitsubishi Trust Bank 50 0 50 0 300 200 100 Sumitomo Trust Bank 100 0 100 0 200 100 100 Mitsui Trust Bank 100 0 100 0 400.2 250.2 150 Yasuda Trust Bank 150 0 150 0 -- -- -- Toyo Trust Bank 50 0 50 0 200 200 0 Chuo Trust Bank 60 32 0 28 150 150 0

Regional Banks Yokohama Bank 20 0 0 20 200 100 100 Hokuriku Bank 20 0 0 20 -- -- -- Ashikaga Bank 30 0 30 -- -- --

Total 1,815.6 321 1,080 414.6 7,459.2 6,159.2 1,300 Note: (a) These debentures are generally of a consol nature and are therefore considered upper tier-2

capital. The only exceptions are those issued by Sanwa Bank and the Industrial Bank of Japan whose debentures are of fixed (10-year) duration and are therefore lower tier-2 capital, which is limited to no more than half of tier-1 capital.

(b) These banks were granted only part of the injection for which they applied. Source: Deposit Insurance Corporation and the Financial Reconstruction Commission.

Table 3. Outstanding Stock and Disposals of Non-Performing Loans, All Domestically Licensed Banks (End of Fiscal Year)

(Unit: Billion yen)

FY1992 FY1993 FY1994 FY1995 FY1996 FY1997 FY1998 FY1999 FY2000 FY2001 FY2002 Non-performing Loans: Outstanding Stock

-- (12,774)

-- (13,576)

-- (12,546)

28,504 (21,868)

21,789 (16,491)

29,758 (21,978)

29,627 (20,250)

30,366 (19,772

32,515 (19,281)

42,028 (27,626)

34,849 (20,433)

Loan Loss Provision: Outstanding Stock

-- (3,698)

-- (4,547)

-- (5,536)

13,293 (10,345)

12,334 (9,388)

17,815 (13,601)

14,797 (9,258)

12,230 (7,678)

11,555 (6,939)

13,353 (8,657)

12,585 (7,897)

NPL Disposals -- (1,640)

-- (3,872)

-- (5,232)

13,369 (11,067)

7,763 (6,210)

13,258 (10,819)

13,631 (10,440)

6,944 (5,398)

6,108 (4,290)

9,722 (7,721)

6,658 (5,104)

New Net LLP -- (945)

-- (1,146)

-- (1,402)

7,087 (5,576)

3,447 (2,534)

8,403 (6,552)

8,118 (15,490)

2,531 (1,339)

2,732 (1,371)

5,196 (3,806)

3,101 (2,042)

Direct Write-offs -- (424)

-- (2,090)

-- (2,809)

5,980 (5,490)

4,316 (3,676)

3,993 (3,501)

4,709 (4,268)

3,864 (3,609)

3,072 (2,650)

3,974 (3,414)

3,520 (3,038)

Other -- (271)

-- (636)

-- (1,022)

302 (1)

0 (0)

863 (766)

804 (683)

548 (449)

304 (269)

552 (501)

37 (25)

Operating Profits 4,685 4,439 4,484 6,753 6,418 5,503 3,129 4,675 4,768 4,693 4,674 Total Loans: Outstanding Stock

474,783 477,150 477,801 482,701 482,312 477,979 472,610 463,484 456,965 440,610 423,286

NPL/Total Loan (%) -- -- -- 5.91 4.52 6.23 6.27 6.55 7.12 9.54 8.23

Capital Adequacy Ratio (%) -- -- -- -- -- -- 10.06 10.88 10.75 10.12 9.52 Note: (1) Data in the table are figures for the Banking Accounts of All Domestically Licensed Banks (i.e., city banks, long-term credit banks, trust banks, and

regional banks) while data in parentheses are those for city banks, long-term credit banks and trust banks. Data for operating profits and capital adequacy ratios also include foreign trust banks.

(2) Non-performing loans in this table refer to “risk management loans” (losses＋loans more than 3 months overdue＋loans with term restructured), except that the definitions prior to FY1997 are slightly different: they are losses + overdue loans for FY1992-94 and losses＋loans more than 6 months overdue＋loans with interest reduced for FY1995-96.

(3) The capital adequacy ratio is the ratio of capital to risk assets. Source：Financial Services Agency; Bank of Japan.

V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND PROGRESS (cont’d)

3. Bank Business Strategies and Consolidation• Consolidation of city banks into four major financial groups

and one weak group (Table 4).-Mizuho Financial Group (January 2003)-Sumitomo Mitsui Financial Group (December 2002)-Mitsubishi Tokyo Financial Group (April 2001)-UFJ Holdings (April 2001)-Resona Holdings (December 2001).

• Banks’ strategic objectives:-Gaining maximum market power in a niche market-Attaining economies of scale-Investing in IT-Investment banking, asset management, fee-based business

Table 4: Banking Groups and Consolidated Assets (Billions of yen)

New Groups Major Subsidiary Banks Former Banks

Consolidated Assets March 2003

End (a)

1. Mizuho Financial Group (MHFG) (Established in January 2003)

Mizuho Bank, Mizuho Corporate Bank, Mizuho Trust & Bankig

Industrial Bank of Japan, Daiichi Kangyo, Fuji, Yasuda Trust Banks

134,033

2. Sumitomo Mitsui Financial Group (SMFG) (Established in December 2002)

Sumitomo Mitsui Banking Corporation (SMBC)

Sumitomo Bank, Sakura Bank

102,395

3. Mitsubishi Tokyo Financial Group (MTFG) (Established in April 2001)

Bank of Tokyo-Mitsubishi (BTM), Mitsubishi Trust & Banking Corporation

Bank of Tokyo-Mitsubishi (BTM), Mitsubishi Trust Bank, Nippon Trust Bank

96,532

4. UFJ Holdings (Established in April 2001)

UFJ Bank, UFJ Trust Bank

Sanwa Bank, Tokai Bank, Toyo Trust & Banking

80,207

5. Resona Holdings

(Established in December 2001)

Resona, Saitama Resona, Kinki Osaka, Nara Banks, Resona Trust & Banking

Asahi Bank, Daiwa Bank 42,892

Source: Individual groups’ website.

V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND PROGRESS (cont’d)4. Linkages with Corporate Restructuring• Corporate sector restructuring is the mirror image of bank NPL resolution.

Resolution of bank NPLs requires real operational restructuring and revitalization of corporations.

• Market-based restructuring—like direct sales of NPLs to the market—is key.• Three frameworks to accelerate corporate restructuring:

-Legal insolvency procedures (Table 5), particularly the Civil Rehabilitation Law (April 2000)-A framework of voluntary out-of-court negotiations for corporate restructuring—based on the London rules of INSOL—including debt-equity swaps-Restructuring through the RCC and IRC

Table 5. Legal and Instituional Changes to Facilitate Corporate Restructuring

Year Changed Laws, Procedures and Institutions Contents 1997 Commercial Codes Procedures for corporate mergers rationalized.

December 1997 Anti-Monopoly Law Establishment of pure holding companies allowed. March 1998 Financial Holding Company Law Establishment of financial holding companies

allowed. 1999 Commecial Codes Share swaps introduced; procedures related to parent

and subsidiary companies rationalized. April 1999 Resolution and Collection

Corporation (RCC) A colletion company to purchase and sell collateral- based NPLs—“in danger of bankruptcy” or blow.

April 2000 Civil Rehabilitation Law (Minji saisei Ho)

Facilitates filings and decisions for large number of firms

2000 Commercial Codes Procedures for corporate splits introduced. September 2001 Voluntary procedures for corporate

debt restructuring based on the London rules (by INSOL)

Guidelines for debt forgiveness agreed.

April 2003 Corproate Restructuring Law (Kaisha kosei Ho)

Restructuring provisions eased and some flexibility allowed in the restructuring measures in line with those of the Civil Rehabilitation Law.

April 2003 Industrial Revitalization Corporation of Japan (IRCJ)

Resturucturing of large firms made easier through purchase of NPLs from all non-main bank creditors.

Source: Financial Services Agency, Ministry of Finance, OECD.

V. POLICY FRAMEWORKS FOR BANK RESTRUCTURING AND PROGRESS (cont’d)5. Regulatory and Supervisory Reforms• Overhauling of the regulatory system and the creation of

the FSA (June 1998).• Prudential norms

-Loan classification and LLP tightened (Program for Financial Revival, Oct. 2002)-Quality of capital—treatment of deferred tax credits-Prompt corrective action fully in place-After a delay, planned reintroduction of a limited (partial) deposit insurance in April 2005

• Resolution of 50 percent of NPLs within a year, and 80 percent of NPLs within two years.

VI. CONCLUDING REMARKS• The bubble in the late 1980s and its collapse were largely

responsible for the emergence of NPLs and the banking sector problem over the last 10 years.

• But the root cause of the problem lied in the lack of prudent risk management by banks.

• The government failed to tackle the problem because of: underestimation of the seriousness of the problem; optimistic expectations of growth; sustained fiscal spending and lack of domestic hardship; lack of domestic and external constraints.

• A more comprehensive framework for bank restructuring put in place since the 1997-98 crisis: temporary nationalization and subsequent sales of non-viable banks; recapitalization of weak banks; tighter bank regulation and supervision; new institutions for bank restructuring.

VI. CONCLUDING REMARKS (cont’d)• Sufficient progress has been made: stabilization of the

banking system, restructuring and consolidation of bank businesses and new incentives for corporate restructuring

• Restoration of a healthy banking system requires: adequate capital base and loan loss provisions; reestablishment of profitable banking business; prudent risk management.

• Recapitalization of banks using public money in itself does not resolve bank NPL problems. Sustained improvements of cash-flows and profitability are needed through better bank management and focus on core competency.

• The banking sector is largely solvent. The risks are concentrated in regional, vulnerable banks to weak local conditions and hikes of the long-term interest rate.