The Essence of Japan's Non-performing Loan Problem

Consulting Fellow, RIETI

Recently, I was called to serve as a witness in a criminal action taken against a financial institution. Having paid illegal dividends without first providing appropriate reserves against the bank's non-performing loans, the managers were the plaintiffs in a court case. This concrete example of legal action in a case of postponing the disposal of non-performing loans by failing to provide adequate reserves against them reveals the essence of the bad loan problem that plagued Japan throughout the 1990s.

Why, it may be asked, is it necessary to dispose of non-performing loans? Strictly speaking, they are investment failures. To pay dividends or executive bonuses before disposing of such loans constitutes a violation of the rules of capitalism. Stunted economic growth is only natural in a society that allows those responsible for such investment failures to go unpenalized.

At the end of the day, the Japanese government is committed to the final disposal of the non-performing loans of the nation's banks. In explaining their policy, however, officials are quick to say that increasing capital ratios (the level of reserves) will not be sufficient to solve the non-performing loan problem, that only a direct method of amortizing them off the books will do the trick. The fact is, however, that inadequate capital ratios often prohibit the direct elimination of bad loans, causing them to remain indefinitely on the bank's balance sheets. As the capital ratio vis-a-vis borrowers facing bankruptcy ought to be near 100%, it becomes difficult for banks to even maintain ordinary financing. These non-performing assets of banks inhibit the yielding of interest on customer deposits, and as such, constitute a breach of trust as well. With the situation having degenerated to this level, it is only a matter of time before a direct method, vis-a-vis corporate debt restructuring, is taken to eliminate the banks' non-performing loans.

Principles of corporate accounting dictate that a reserve be immediately established to offset non-performing loans. The rule at play here is not to postpone the disposal of bad loans in anticipation of an economic rebound. In practice, however, it is difficult for the outsider to determine whether or not appropriate reserves are being maintained by a bank. In all prior cases of financial institution collapse, the bank managers, government auditors and even external auditors all claimed before the collapses that sufficient reserves were on hand. This adds impetus to the need for disclosure; however, due to privacy issues, especially borrower-related information, there are limits to its implementation. Given such factors, it will most likely continue to be only the managers of a bank who know whether appropriate reserves have been put in place or not.

Over the past ten years, the level of reserves held by banks vis-a-vis their non-performing assets has clearly been low. This must be due to one of two reasons: either the managers deliberately provided insufficient reserves or they did not know the proper level of reserves to provide. If deliberate, the managers' responsibility must be rigorously pursued. By holding them criminally liable, considerable influence can be exerted on bank management; and by expelling the culprits, the banking industry can be expected to enjoy a brighter future.

If the reason is nonfeasance, not misfeasance, on the part of the managers, however, the problem is much more serious, as merely expelling them will not yield a solution. In order to maintain the proper level of reserves, banks need an effective system of credit risk management that functions to show the future amount of unrecoverable loans based on claimable assets. In this case, the reason for a proper level of reserves not being maintained is inferior financial management technology within the banking industry.

My intuition tells me that the reason banks have not provided adequate reserves but rather opted to postpone the disposal of their non-performing assets over the past decade is due in part to a desire to avoid deficit balance sheets while hoping against hope for an economic recovery. I'm afraid, however, that the second factor, the immaturity of their financial management tools and techniques, is more at the root of their actions or lack thereof. Whereas bad loans were created by irresponsibility and immature investment techniques on the part of bank management, the inability to dispose of them expeditiously is the result of immature credit management techniques on their part as well.

September 11, 2001

September 13, 2001