Japan’sRegulatoryResponsetoBankingProblemsMasamiImai(WesleyanUniversity)NineteenthAnnualInterna7onalConference--AchievingFinancialStability:ChallengestoPruden7alRegula7onNovember3,2016

Outline•  Economistshavedocumentedthegovernment’sregulatoryresponsetobankingproblemsinJapan(e.g.,Cargill,Hutchison,andIto,2000,HoshiandKashyap,2000,Watanabe2014)

•  Isynthesizetheliteratureandaddmorerecentdevelopment.•  PartI

•  RegulatoryfailureintheaUermathofthecollapseofassetpricebubbleinJapan

•  Economicimplica7onofregulatoryfailure•  PartII

•  Morerecentpolicydevelopment•  Preliminaryassessment

Facts•  Japanenduredoneofthelongestbankingcrisesinrecenthistory!!•  Thebankingproblemstartedwiththecollapseofassetpricebubblein1990

•  BanksrestoredfinancialhealthwithTakenakaplanatlonglast(2002-2005)

•  Foroveronedecade,alargesegmentofbankingsectorwasallowedtooperatewithinsufficientcapital(i.e.,forbearancepolicy)•  Regulatorsunderminedmarketforcesthatcouldhavemonitoredanddisciplinedproblembanksbe^er

•  Banksresortedextensivelyto“regulatorycapitalarbitrage”toboosttheircapital-to-assetra7osinar7ficialmanners

•  Regulatorsfailedtosetupaproperruletoassessthesizeofnon-performingloans

MarketDiscipline•  Banksfacemarketdisciplineifinvestorshavefinancialincen7vestoavoidproblembanks•  Thelargeliteratureonthistopicsuggeststhatextensivefinancialsafetynetunderminesmarketdiscipline(e.g.,Demirgüç-KuntandHuizinga,2004)

•  InJapan,thefinancialsafetynetwasextensiveandalsoexpandedastheproblemgotworseover7me

•  “Convoysystem”•  TheMOFusedmoralsuasion/regulatoryrentstoforcehealthybankstotakeoverproblembanks(Hoshi,2002)

•  Depositinsurance•  TheDICinsuredupto10millionyenun7l1996•  TheJapanesegovernmentins7tutedtheblanketguaranteeofalldepositsfor6yearsfrom1996-2002

HowDidMarketDisciplineWork?•  DepositinsuranceschemeaffectedtheintensityofmarketdisciplineinJapan

•  Boththequan7tyofdepositsandtheinterestrateondepositsrespondlesssensi7velyunderblanketdepositguarantee(e.g.,MurataandHori,2006;Imai,2006)

•  Depositorsmadeli^ledis7nc7onbetweenhealthybanksandweakonesandallowedthela^ertogrowwithoutfinancialpenalty

SubordinatedDebt•  Reportedbankcapitaldeclinedtodueafallinunrealizedcapitalgainontheirsecurityholdings(Fukumi)

•  Banksissuedalargeamountofsubordinateddebttomakeupforcapitalshorjall

•  Mi7gatedcreditcrunchtosomeextent(ItoandSasaki,2002;Montgomery,2005;Iwatsubo,2007)

Ito and Sasaki (2002)

MarketDisciplineinSub-DebtMarket•  Sub-debtsarerisky

•  Poten7altoplayanimportantroleinmonitoring/discipliningbanks(FlanneryandSorescu,1996)

•  InJapan’scase,investorsdidnotdis7nguishweakbanksbefore1998(Imai,2008)•  Privatelyissuedandheldby

keiretsu-relatednon-financialfirmsandinsurancecompanies(HoriuchiandShimizu,1998;Fukao,2002)

•  Theyarelikelytohavean7cipatedgovernmentbail-outaswell

Subordinated debts spread for Japanese banks (1993–2004): Imai (2008)

RegulatoryCapitalArbitrage•  Banksmanipulatedregulatorycapital-to-assetra7osinvariouswaysthatwouldnotalterthetrueeconomicvalueofbankcapital

•  AccordingtoBaselAccord,Japanesebankscouldcount45%ofunrealizedgainsontheirstockholdingsas7erIIcapital,but100%ofretainedearningsas7erIcapital•  Soldstockstorealizecapitalgainsandthenpurchasedthembacktomaintaincross-shareholdings(ShrievesandDahl,2003)

•  Itbecameincreasinglymoredifficultbankstoraisecapitalra7osthroughthesalesandre-purchaseofstockholdingsinthelate1990s

•  Thegovernmentbeganallowingbankstocountdeferredtaxassetsascapital(Fukao,2002;Skinner,2008)

PerverseIncentiveStructure•  WidelydocumentedintheJapanesemediaaswellasintheacademicliterature(e.g.,Sekine,Kobayashi,Saita,2003;PeekandRosengren,2005)

•  Foreverynon-performingloan,thereisanon-performing(zombie)borrower

•  Abankwhoseownsolvencyisques7onablekeepslendingtoazombiefirmtokeepitsloancurrent•  Otherwise,thezombiefirmisforcedtorestructureordeclarebankruptcy,which,inturn,increasesthereportedNPLsforthebank

•  Thegovernmentlargelyignoredtheseverityofhiddenbadloanproblem,basedonhopeandfear•  Hope:economicrecoverywillsolvethenon-performingloanproblem

•  Fear:thefiscaland,moreimportantly,thepoli7calconsequenceofmassivebankruptcies

•  Banks,zombiefirms,andthegovernmentallhadstrongincen7vetohidetheextentofbadloanproblemsfromthepublic

EconomicEffectsofZombieLending•  Itfavorsunproduc7vefirms

•  DispersioninMPK•  Unproduc7ve(produc7ve)firmswillbecharacterizedbyoverinvestment(underinvestment)andandlowMPK(high)

•  Caballero,Hoshi,andKashyap(2008)showthatzombiefirmsdistortedtheentrydecisionofproduc7vefirmsaswellastheexitdecisionofunproduc7vefirms

BankingCrisis(1997-1998)•  SanyoSecuri7es(amid-sizedsecurityfirm),HokkaidoTakushokuBank(amajorbank),andYamaichiSecuri7es(amajorsecurityfirm)failedin1997

•  VotersbecameincreasinglydiscontentwiththerulingLiberalDemocra7cParty’s(LDP's)handlingoffinancialandeconomicaffairs

•  TheLDPlostitsmajorityintheJuly1998UpperHouseelec7on.

•  TheLDPhadtomakeacompromisewiththelargestopposi7onparty,theDemocra7cPartyofJapan(DPJ),whichhadlongadvocatedfortheimmediateclosureandna7onaliza7onofinsolventbanks

October1998•  ThenewDietenactedtwoimportantlaws

•  TheRapidRecapitaliza7onAct(RRA)•  TheFinancialReconstruc7onAct(FRA)

•  FRA•  CreatedtheFinancialReconstruc7onCommission(FRC)•  S7pulatedaformalmechanismunderwhichtheFRCcouldresolveinsolventins7tu7ons

•  RRA•  Providedalegalbasistoinjectpubliccapitalintoundercapitalizedyetviablebanks

•  ThenewlycreatedFinancialSupervisoryAgency(FSA)commencedaggressivebankexamina7onsin1999

SlowProgress•  Asthebankingcrisissubsidedin1999,thegovernmentbegantoloseitszeal•  ThechairoftheFRC,HakuoYanagisawa,whowaswidelycreditedforhis

aggressiveapproachtotakeoverinsolventbanks,wassackedin1999andreplacedbyMichiOchi,aformerMOFbureaucratandconsummateLDPinsider.•  “We'renowmostworriedaboutcreditassocia4onsandcoopera4ves.Government

financialinspectorswillauditthembetweenJulyandnextMarch.Ifyouthinkauditsonyourins4tu4onsaretoostrict,pleaseinformusaboutit.PleasetellMr.Hasumiaboutit.Ifyougiverelateddocumentstohim,andhewillinturnpassitovertome,I'llgivetheutmostconsidera4on.”—AspeechbyFinancialReconstruc7onMinisterMichioOchiatagatheringofregionalbankersandcreditassocia7onsandcoopera7vesofficialsinTochigiprefecturehostedbySusumuHasumi,aseniorLowerHousememberoftherulingLiberalDemocra7cPartyonFebruary19,2000

•  InJanuary2001,YanagisawawasbroughtbacktoserveastheheadoftheFinancialServicesAgency,whichtookoverthetasksoftheFRCandtheFSA•  However,hecon7nuedthepolicyofdenyingthepresenceoflargenonperforming

loansandinsistedthattherewasnoneedforanotherroundofcapitalinjec7on

TakenakaReform•  InAugust2002,thegovernmentreplacedYanagisawawithnonpoli7cianHeizoTakenaka

• Calledforastrictaccoun7ngstandardandtheresolu7onofproblemloans

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1998h1 2000h1 2002h1 2004h1 2006h1 2008h1 2010h1 2012h1 2014h1 2016h1Year

MajorBanksvs.RegionalBanks

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Major Banks Regional Banks

RegulatoryResponsein2008-2009•  TheexposureoftheJapanesebankstosub-primeloanmarketswaslimited,buttheseriouseconomicdownturnensued

•  Bankswererela7velyhealthybutsmallandmediumsizednon-financialfirmshaddifficultypayingbackdebts

•  Thegovernmentseemstohaverevertedbacktotheoldhabit(Harada,etal.2015)•  e.g.,DebtMoratoriumLaw

DebtMoratoriumLaw•  TheLDPlostthemajorityintheLowerHouseElec7onsin2009•  TheDPJ,nowincontrolofbothlowerandupperhouses,proposedtoforcebankstoaccepta3yearmoratoriumforSMEs

•  Thecompromisedwasreached•  Bankshaveobliga7onstomaketheutmostefforttorescheduleloansforsmallandmediumsizeenterprises(SMEs)

•  FSAallowsbankstoexcludetherestructuredloansfromnon-performingloans

•  FinancialServicesMinisterShizukaKamei•  “AslongasI’mfinancialservicesminister,I’mnotgoingtoleavesmallcompaniesinthelurch,unabletogetloans.Ifabanktakesthatapproach,I’llhitthemwithabusinessimprovementorder.”

•  Thefinalbill,theDebtMoratoriumLaw,wasapprovedinNov2009

DebtMoratoriumLaw,cont.•  Itwassettoexpirein2011buttwiceextendedto2013

•  Eventhoughthelawexpired,theFSAcon7nuedto•  EncouragebankstoextendloanstodistressedSMEs

•  Allowthemtoexcludetheserestructuredloansfromnon-performingloans.

Harada, et al. (2015)

HiddenNon-PerformingLoansatRegionalBanks

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Major Banks Regional Banks

Total NPLs Restructured Loans

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Graphs by banktype

EconomicImplicationsofDebtMoratoriumLaw•  Intheory,thedebtmoratoriumlawmighthavemi7gatedcreditcrunchforSMEs,butithasbecomemoredifficulttoassesstheextentoffinancialproblematsmallbanks

•  Itmighthaveunderminedmarketdisciplineandpromotedmoralhazardproblemagain

•  Italsosetsupafinancialenvironmentinwhichzombiefirmstendtothrivejustastheforbearancepolicyhasdoneinthe1990s

•  Moreover,itmighthavesignaledtofinancialmarketsthatthepoli7calincen7vestobailoutzombiefirmsremainpowerfulinJapan

ConcludingRemarks•  Japan’sresponsetofinancialcrisisiswidelyconsideredfailure•  Regulatorsunderminedmarketdisciplineandallowedweakbankstogrowandcon7nuetolendtounproduc7vezombiefirms•  Manybelievethatthisregulatoryfailurecontributedtoslowproduc7vitygrowthinJapan

•  Recentdevelopmentseemstoconfirmthatthepoli7calincen7vetoprotectzombiefirmsremainsstrong