The Japanese Banking Crisis of the 1990s

Background

In the postwar period, Japanese banks were heavily regulated by the Ministry of Finance (MoF) and also closely watched over by the central bank under the convoy system where supervision and regulation was led in a way that did not destabilize the viability of the weakest bank. In other words, the banking sector was a fail-safe because the MoF was expected to step in to help any threat against the viability of a bank. In return banks were expected to work as financial intermediaries channeling surplus household savings to the industrial sector, this system was designed to rebuild Japan after WWII. Financial institutions were treated more as providers of public financial services. As interest rates were also regulated, there was limited competition among financial institutions to offer more favorable rates. Any new financial product required authorization by the MoF which granted the product to all the institutions at the same time, therefore there was little incentive for a financial institution to develop new products or services to gain relative advantage and profitability. Everyone took for granted that banks were never allowed to fail under the convoy system which so far has proved to work and contributed to economic growth. The measures of financial deregulation in Japan started in the early 1970s on a step by step basis to avoid any negative impact on the financial sector. Meanwhile, as a safety net for the financial system, the deposit insurance system was established in 1971. A Deposit Insurance Law was revised, under this legislation the Deposit Insurance Corporation (DIC) was provided with 2 policy options: #1 was a payoff in which a failed bank would be closed down for liquidation and a every depositor with the failed bank would be protected with 10 million yen. #2 was financial assistance by the DIC where the assets and liabilities of a failed bank would be transferred to an assuming bank. This second method was thought to have less negative impact on the financial system stability.

In the second half of the 1980s the Japanese macroeconomic environment showed an above-trend economic growth and near-zero inflation which resulted in a decline in the country risk premium and growth expectations boosting asset prices and fueling credit expansion. Also, there was an accelerated financial liberalization and deregulation which consisted of relaxation of interest rate controls, capital market regulation where euro-yen loans where prohibited(as they were not subject to interest rate controls) Japan first experimented problems with its financial institutions after 1991 once the bubble burst. These problems however were limited to small institutions. Even though stock prices had been declining since the beginning of 1990, there was still optimism that once Japan recovered from the burst of the bubble the economy would be back on track. This confidence led the authorities to a wait-and-see policy prolonged until 1994. Collapse of the Bubble The highly overvalued Japanese stock market peaked at the end of 1989, this lead to an increase in the discount rate in the Bank of Japan and then collapsed after the summer of 1990. The MoF limited total bank lending to the real estate sector to cover the continued rise in land prices by introducing new guidelines. This lead to the leveling off of Japanese banks asset growth, with a total asset declining from 508 trillion yen in 1989 to about 491 trillion yen in 1990. In 1992 land prices officially started to decline. This drastic decline in stock and real estate prices damaged the health of banks and other financial institutions by: first, prices falling by half therefore deteriorating the quality of loans to the real estate industry rapidly. Second, eroding the value of collateral. For example since prior to 1991 many borrowers could borrow up to 90% of the value of their real estate collateral, about 50% drop in real estate prices between 1991 and 1998, meaning that 40% of the loans became uncovered. And third, the decline in the value of banks equity holdings began to put pressure on bank capital. The deceleration of economic growth reduced the ability of debtors to continue to service their loans. The many banks that had previously enjoyed higher credit ratings than their corporate borrowers saw their marginal costs of funding rising above those of their borrowers. This lead to an acceleration in new bond issues, the percentage of funds raised by the corporate business sector rose from 3,6% to 24,5.
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Economic and Political Impact (1991-2000) The lost decade, as the Japan financial crisis of the 1990s came to be known, was the result of the countrys bubble burst. First of all, the government not only did not prevent the housing price from soaring, it encouraged it. According to an article published by the New York Times, the Ministry of Finance was worried that a strengthening yen was hurting Japanese exporters, and insisted on banks to lend to real estate developers so that a building boom and an increased consumer spending would lift the economy1. The evolution of the Japaneses economy is described in three stages and corresponds with changes in U.S economic policy toward Japan. The U.S policy influenced Japan in different ways as: political pressure, public relations campaigns, economic sanctions and trade negotiations but what characterized the 1990s was the importance of markets specially, the foreign exchange and equity markets, which transmitted U.S policy toward Japan. The first division of the Japaneses economy is the recession caused by falling plant and equipment investment from fiscal 1992 to 1994, from fiscal 1995 to 1996 and the last stage a surge in deflationary pressures resulting from de destabilization of the banking system, from fiscal 1997 to 1998. Also is important to add the period when the long recovery began, from fiscal 1999. Recession caused by falling plant and equipment investment from fiscal 1992 to 1994 During this period was the transition from the Bush to the Clinton administration and the goal was to change the Japanese economy and political system. For the United States the strength of the Japanese economy was derived from a closed hierarchical structure called Japan Inc. This was the nickname for the corporate world of Japan that came about during the 1980s boom, when Western business people saw how closely the Japanese government worked with its nation's business sector. The high degree of collusion between Japan's corporate and political sectors led to corruption
1 Lohr, Steve. "From Japans Slump in 1990s, Lessons for U.S." The New York Times. 09 Feb. 2008. Web. 24 July 2011. <http://www.nytimes.com/2008/02/09/business/worldbusiness/09japan.html?pagewanted=2>.
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throughout the system and contributed to the downfall of the overvalued Nikkei. (The Nikkei Index is a stock market index for the Tokyo Stock Exchange, TSE). At the top of this Japan Inc. hierarchy, were the big Keiretsu companies that were highly connected with banks, so when a bank was in financial distress, it was temporarily bailed out by other members of the corporate group. This proves how Japanese bank regulations were very friendly and permissive; the bureaucracy (the ministry of finance) and the ruling political party (the Liberal Democratic Party). This theory was popular among Americans and Japanese. The focal point of the economic relationship between the U.S and Japan were the negotiations on Japanese structural impediments. Late 1994 1996 Once the bubble burst, sporadic failures of financial institutions arose, but they were limited to relatively small institutions and they were regarded as isolated events that would have little implications. The general expectations were that the economy would soon recover, so the government decided to implement a wait-and-see policy. In December 1994, Tokyo Kyowa and Anzen, two urban credit cooperatives, failed. Both had been ill-managed institutions, with a combined deposit size of 210 billion. The government did not know how to deal with the situation since that constituted the first failure of urban deposit-taking institutions. The pertinent authorities that had to deal with the case were the Tokyo Metropolitan Office (primary supervisor of the credit cooperatives), the Ministry of Finance and the Bank of Japan. They had a hard decision to take because no institution was willing to absorb the assets and deposits of the cooperatives and law only allowed a payoff by DIC up to a certain amount. If depositors incurred losses, large-scale bank runs may be triggered and there were many unhealthy banks that would not be able to survive. In the end the Bank of Japan established a new bank, called Tokyo Kyoudou Bank (TKB) to assume the obligations of the two failed cooperatives. The Bank of Japan subscribed 20 billion of capital and private financial institutions subscribed another 20 billion. The latter would also provide the new bank with a low-interest loan to support its profitability.

In July 1995, Cosmo Credit Cooperative failed, followed by Kizu Credic Cooperative and Hyogo Bank only a month later. For the latter a new bank, Midori Bank, was established. While for the first two, Tokyo Kyoudou, the bank that had just been created months before absorbed the capital and the deposits. In fact, in 1996, the Tokyo Kyodou Bank was reorganized into the Resolution and Collection Bank, with the wider role of a general assuming bank for failed credit cooperatives, in the occurrence that no private assuming bank could be found. Japans financial system continued to tremble. In September 1995, Daiwa Bank, an internationally active bank, announced that it had incurred a loss of approximately $1.1 billion as a result of the fraudulent conduct of an employee at its New York branch. Two months later, the bank was ordered by the US regulators to close all operations in the US markets. The incident greatly harmed the reputation of Japanese internationally active banks and weakened confidence in Japans financial system. What had begun as a domestic banking problem was now developing into a crisis of international dimensions. The Jusen trouble, which had first been heard of in 1993, became a major issue from 1995 to 1996. Jusen, also known as housing loan corporations, were non-bank financial institutions that were founded by banks and other financial institutions in the 1970s to complement their housing loans. In the 1980s they had shifted their funds towards lending to real estate developers. They lacked expertise and by 1995, the seven jusen companies had a compound loss of 6,410 billion. The losses were far beyond the amounts that founder banks could possibly cover. The government stepped in and approved a package that allowed the use of taxpayers money. In the package, the losses of the jusen companies were allocated to the founder banks (3,500 billion), lender banks (1,700 billion) and agricultural financial institutions (530 billion). The residual 680 billion ($6.7 billion) was to be covered by the taxpayers money. Up to that point taxpayers money had not directly been used to deal with the failures in the financial system. The decision led to strong public resentment, especially because the jusen companies were nondepository institutions that had nothing to do with their daily lives. The public resentment was so strong that until fall of the following year, it became almost a political taboo to refer to any further use of public funds to address the banking problem. The public money injected in the jusen fiasco

amounted to 685 billion, which seems small when compared to the 60,000 billion of public money that was later introduced to clean up the banking mess. Japanese population characterizes for its culture of frugality in bad economic times; but this turned against the economy, deepening the recession; Japan needed consumption, not people holding to their savings. Many people feared that the high debt incurred by the country to be injected in the financial sector, would impede the government from paying for their future pensions, so even now, Japans aging population prefers to save rather than spend2. Deflationary pressures resulting from de destabilization of the banking system, from fiscal 1997 to 1998. The international financial crisis in Asia and the bankruptcy of three major financial institutions in 1997 caused the financial crisis of Japan. The GDP during this year was -0.7 percent sending the economy back to recession same to what happened during the period of 1992-94. The Japanese premium on interbank lending reached 1 percent, Japanese banks faced difficulties in obtaining funds in international markets and also U.S and European banks gradually reduced their credit lines to Japanese banks. On the other hand, interest rates for procurement of yen funds by foreigners dropped to near zero and were negative in some cases. The net selling of Japanese stock of foreigners was 591.4 billion and within a month it went up to 754.5 billion. Foreign trading of Japanese stocks recovery temporarily due to the Deposit Insurance Law and the law on emergency measures to stabilize financial functions, but the selling weakened the yen. Large scale market interventions and the tax cut temporarily increased the yens value to more than 130 against the dollar. The governments efforts to intervene could not strengthen the yen that is why they combine policy commitments between the U.S and Japan. Washington demanded clear plans to dispose of banks bad loans and additional stimulus measures. After the negotiations Japan and the United States began joint intervention in New York. The yen rose from 6 to 137.60 against the dollar in

2 Denny, Charlotte. "Japan's Zombie Economy." The Guardian. 20 Nov. 2002. Web. 24 July 2011. <http://www.guardian.co.uk/business/2002/nov/20/japan.internationalnews>.
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foreign markets. The intervention did not last long, the yen started to weaken 140 per dollar. The crisis spread to Latin America and finally to Wall Street. In 1998, the U.S Treasury emphasized on the liquidation of insolvent banks and the restructuration of solvent banks. Washington was worried of the consequences that a collapse of the Japanese financial system would spread to New York. Non-Performing Loans (NPLs) After the bubble burst the capacity of banks to extend new loans was constrained by the deterioration in their capital positions. The tightened credit conditions discouraged business fixed investment by the corporate sector. Medium and small-sized corporations were hit most severely as their alternative sources of funding were generally limited. The resultant economic contraction further undermined the asset quality of banks, thus maintaining the financial system and the real economy in a vicious circle that dragged the economy into a recession. As a consequence, the recession became deeper and it lasted longer than had been widely expected and the cost and time for overcoming the financial crisis grew that much larger and longer. In Japan, the banking sector is the dominant supplier of credit to corporations. Banks were greatly exposed to the risk arising from falling land prices, because a large part of their loans were secured with real estate collateral. By 1999, urban real estate prices plunged by 80% to pre-bubble levels by 1999, generating more non-performing loans (NPLs) year after year. Japanese banks had limited incentives to remove their NPLs from their balance sheets because the carrying cost, or the opportunity cost, of holding NPLs was very small since the Bank of Japan maintained a loose monetary policy and interest rates remained at extremely low levels. Additionally, liquidation of NPLs was almost certain to magnify losses, because sales of bad loans were only possible at deeply discounted prices. Such a prospect of further losses must have discouraged Japanese banks from disposing of bad loans on a large scale. Up to the first quarter of 2000, 110 deposit-taking institutions were dissolved under the deposit insurance system (under the system, financial institutions pay insurance premiums to the DICJ in order to protect depositors in the event of a failure of a financial institution). The total amount

spent in dealing with the non-performing loans from April 1992 to March 2000 was 86 trillion (17% of GDP), which included3:

Charge-off and provisioning by banks Transfers by the Deposit Insurance Corporation to cover losses of the failed institutions Capital injections to banks.

Banks in Japan began writing off their bad debt in the mid 90s, but it was not until 1999, when the Resolution and Collection Corporation was formed to manage the process, that the governments bail-out started. Free to lend again, many banks used funds to keep zombie companies (companies that are not profitable and need constant financial help) operations, in order to avoid bankruptcy and mass unemployment. Current situation and aftermath
In between the years 1990 and 1991, the stock market bubble and the real property industries, were being under financial deregulation due to an expansive monetary policy. The main reasons why the prices were incommensurable high were due to the incessant increase in the interest rates since the late 1989, to control inflation. Indeed, in 1990 the Nikkei index become a 50% lower its base after nine months of having decided those regulatory policies. In addition, the real property industry started to become devaluated to half of its price in 1991; after a sustainable increase nine years ago ("The Financial). In 2003, prices leveled out to its previous scenario in 1980. After having passed through this atypical banking situation, there were some important answers which basically were focused on expansive fiscal and monetary policies. Between the 1992 and 1999, there were set up nine fiscal programs in the Japanese economy, valued around 130 billion yens , in other words it represented a 25% of the total GDP. As a matter of fact, from 1990 to the year 2000, from 2, 9% of the budgeted balance bumped down to -6,8%; almost a 10 percent variation in the GDP was registered (The Japanese).

3 Nakaso, Hiroshi. The Financial Crisis in Japan during the 1990s: How the Bank of Japan Responded and the Lessons Learnt. Publication no. 6. BIS, 2001. Print.
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Furthermore, the public debt arose from 65% of the total GDP in 1990, to 151% in 2002. It is imperative to highlight that the Japanese government took into consideration monetary and fiscal measures after having passed two years of the crisis- i.e.- the so called bubble burst. On the other hand, the monetary policy was handled in such low pace to finally reach a zero percent interest in year 1990. Since 2001, it was also reached a consensus to apply as well as facilitate a quantitative easing ("The Japanese). This policy was oriented to increase deposits: (e.g.- cash inflows) in the Japanese central bank, to later on redirect those inflows to commercial banks. Regardless of this policy, commercial banks in general were reluctant to lend money because of the high non-performing loans rate (NPL). In brief, each of those policies: fiscal and monetary one, were inefficient to battle down deflation during that decade; nonetheless, definitely it would have been worse if those policies had not honored the financial crisis. The lesson which can be inferred from this banking crisis can be summarized as follows: the fact in which Japan possessed a significant domestic pressure the government was able to become used to practicing a Keynesian fiscal policy to provide resources to insolvent corporations (e.g.- financial and real property). One of the most crucial factors to be faced by the time was the incongruent accounting system which was being used in the Japanese banking sector. Indeed, due to this reason the economy was unable to recover faster ("The Financial). If the government had sent clearer messages to the banking sector, this sector could have avoided recognizing loan losses through tax incentives or rapid liquidation of troubled assets. Another problem which happened to definitely solve this crisis was the lack of legal framework to control the banking system efficiently, for instance, the lack of operational procedures, and the lack of contingency plans to cover capital shortages. Nonetheless, in 1998 this legal framework was achieved to finally convince politicians to handle crisis at an early stage. As a result, this is one of the first lessons to be acquired, most of the time liquidity problems can appear; thus the national government should plan in advance recapitalization if needed and other policies. Public recapitalization can be effective if the total amount of money is greater than the debt itself; for example in Japans scenario: the first capital injection was of 1.8 trillion yens, when the total debt was of 22 trillion yens by that time. Of course it is significant to remove those assets which affect directly to the financial institution due 9

to the banks recovery from crisis. Sometimes during this critical period the government acquires those assets from the financial institutions to somehow restructure the banks balance sheets during a crisis. The Resolution and Collection Corporation (RCC) in Japan, bought assets from banks in bankruptcy in October 1998, and from solvent banks too. Indeed, probably some NPLs were covered by the injection of 353 billion dollars between October 1998 and March 2005 in the banking system but capital injections without economic recovery are not effective ("The Japanese). There are profound connections between Japans banking crisis and the current one which hits the American government from year 2007 to 2009 ("Financial Crisis). Both of them needed capital injection and rapid state acquisition of assets. As a result, the formation of an asset bubble close to burst was the cause to look after deleverage; overvaluation of assets and the collapse of real property and the breakdown of some financial institutions such as: Yamaichi and two other credit banks in Japan as well as Lehman Brothers and other leveraged enterprises in America. Until the fall of 2008, Japanese financial sector was not affected by the USA recession because of the small amounts of money invested in its financial products. Even though, Japan continued to record negative growth, year after year, from the second quarter of 2008 to the fourth quarter in 2009. In order the American market can achieve sustainability and infer Japans teaching on the financial sector; Americans should remove NPLs from their balance sheets.

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Works cited "The Financial Crisis in Japan during the 1990s: How the Bank of Japan Responded and the Lessons Learnt." Bank for International Settlements. Web. 25 July 2011. <http://www.bis.org/publ/bppdf/bispap06.htm>.http://www.bis.org/publ/bppdf/bispap0 6.pdf?noframes=1/ "The Japanese Banking Crisis 1990." IMF. Web. 25 July 2011. <http://www.imf.org/external/pubs/ft/wp/2000/wp0007.pdf>. "Financial Crisis Management: Lessons from Japans Lost Decade | Vox - Researchbased Policy Analysis and Commentary from Leading Economists." Front Page | Vox. Web. 25 July 2011. <http://www.voxeu.org/index.php?q=node/2483>.

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