Two Years is Too Short to Solve Nonperforming Loan (NPL) Problems

Visiting Fellow, RIETI

Recent Developments: Government Program for Accelerating NPL Disposal Fails to Lift Market Sentiment

At the end of July, Prime Minister Junichiro Koizumi instructed that the introduction of the "payoff" limited deposit protection system should be postponed. In September, the Bank of Japan unveiled plans to purchase shares held by banks. Despite repeated assurances from ministers and the BOJ director that Japan is in no danger of a banking crisis, market participants remain unconvinced. The message they hear in the latest course of events is that Japanese banks' balance sheets have deteriorated to a degree that compels the government to postpone lifting full deposit protection and the central bank to buy shares from banks. As a natural reaction, traders would opt to go short on bank shares. Indeed, bank shares have been under sustained sell pressure this year. In the Sept. 30 reshuffling of the Cabinet, Prime Minister Koizumi appointed Heizo Takenaka - regarded by the financial industry as an economic expert, but with a lesser reputation in the world of finance - not only to serve in his previous post as economic and fiscal minister, but to wear yet another hat, that of financial services minister. Despite the number of finance experts among elected legislators, the prime minister did not dare to give a chance to any of his fellow members of the Liberal Democratic Party. In the weeks following his assumption of the new post, Financial Services Minister Takenaka made a series of imprudent remarks." Stock prices continued to fall (Mizuho Holdings shares plunged more than 40 percent between Oct. 1 and Nov. 11). Minister Takenaka then unveiled the Program for Financial Revival, a comprehensive counter-deflationary package that also includes a set of schemes to accelerate the disposal of NPLs. The program set a clear direction, urging the government to press forward with the disposal of NPLs and the restoration of companies and industries in a cohesive manner. To accelerate NPL disposals, the program calls for compulsory adoption of the discount cash flow method by banks when calculating necessary reserves for loan losses. This is included in the package, and rightly so. However, the NPL problems will clearly not be solved in a mere two or three years. The implementation of the program will accelerate direct write-offs of NPLs, or the complete removal of NPLs from bank balance sheets. But it remains questionable whether this will revive the Japanese economy. Unfortunately, the program has not proceeded to the point where market participants are convinced bank stocks have bottomed out.

Mounting NPLs Weigh Heavily on Bank Management; Stock Prices Continue to Fall

The presence of highly rated prime banks is an essential component of a free market economy. Credibility is the very backbone of bank operations. But the very credibility of Japanese banks is eroding; today, only two Japanese banks are perceived as full-fledged players in the international financial market. Japanese banks have lost much of their management vitality under the twin burdens of snowballing NPLs and falling stock prices.

1) Rise in Newly Generated NPLs
During the past several years, major Japanese banks have struggled in the red, with business profits swallowed by the disposal of NPLs. In fiscal 2001, ¥6.5 trillion worth of NPLs were written off by 137 banks nationwide, according to the daily Nihon Keizai Shimbun. But since then, an additional ¥8.6 trillion in loans has become non-performing, bringing total outstanding NPLs to ¥32.5 trillion as of March 31, 2002, an increase of ¥2.1 trillion from the previous year, due in part to asset deflation. On Nov. 8, the Financial Services Agency announced that the total amount of NPLs held by major banks stood at ¥47 trillion, according to its own estimates (35% more than the ¥32 trillion reported by the banks themselves). Under the mounting burden of NPLs, bank managers face great difficulty in assuming risks and taking on new borrowers. The weight of the NPLs makes it virtually impossible for banks to advance into new fields of business.

2) Changes in Accounting Rules
Under the mark-to-market accounting system introduced in September 2001, declining stock prices hit bank balance sheets by expanding valuation losses on their cross-shareholdings. Valuation losses held by major banks as of the end of September 2001 exceeded ¥5 trillion. This is an outcome of a decision by the Japanese Institute of Certified Public Accountants to adopt the mark-to-market system in accounting for cross-shareholdings, a move to bring the Japanese accounting system more in line with global standards. Bank managers have always been particularly edgy about stock prices at the end of each half year and fiscal year, namely, on Sept. 30 and March 31. Bank balance sheets are now influenced by factors unrelated to their own management capability. (Bank capital basis must be reduced by an amount equivalent to 60 percent of valuation losses). The mark-to-market system is not used either in France or Germany, where banks characteristically have large share holdings. Senior officials of French banks insist that it is misguided to evaluate crossshareholdings that are not held for trading purposes at market price.. Thus, banks in France and Germany continue to use book values. With the stock price index in both countries falling some 40 percent this fiscal year, this practice has been a source of some relief. Japan, however, has crossed the Rubicon. There is no returning to the book value system. While I do not oppose the mark-to-market system, I believe Japan could have been more prudent in the timing of introducing this system. The introduction of the mark-to-market system surely compounded management burdens at major banks, which were already hobbled by the issue of NPL disposal.

3) Restrictions under BIS Capital Requirements
The presence of Japanese banks overseas is important for Japanese companies operating in the global market. Thus, it is important for Japanese major banks to maintain an 8 percent capital adequacy ratio, the minimum standard for healthy banks set by the Bank of International Settlements (BIS). However, it is unclear why the minimum standard was set at this particular figure. What is clear is that this rule, in a declining economy, binds bank managers and forces them to opt for measures to maintain capital adequacy ratio - that is, to compress assets, as the denominator, in accordance with the decrease in capital, the numerator. More specifically, banks move to curb lendings to corporate customers that may turn sour and increase their investment in government bonds categorized as zero risk assets. Bank investment in government bonds has exceeded ¥80 trillion, more than doubling the figure for 1998. As long as dividend-seeking shareholders are satisfied, it may be difficult for the government to check banks' move to reduce lending to small and midsize companies. Nevertheless, as a major shareholder, the government should express its views and secure capital flows to private sector companies.

Actions that the Government Must Take Now

Government officials have been unable to draw up a grand design to mobilize the entire government to move in one direction, to devise a plan that would win the approval of the rest of the world, a scheme worthy of a country which in a relatively brief period attained the stature of the world's second largest economy. More than likely, this inability is due to fears that such a scheme would constitute "painful reforms," accompanied by unemployment and industrial reorganization. But to revive this country, the government must take that risk and act boldly.

1) Depth of Deflationary Slump must be Recognized First
With the bursting of the bubble economy, Japanese real estate shed ¥900 trillion in value, slipping from ¥2.4 quadrillion in 1990 to ¥1.5 quadrillion in 2000 (System of National Account). Likewise, the aggregate value of Japanese stocks fell from ¥900 trillion in 1989 to some ¥300 trillion - based on the Nikkei stock average of 10,000 -, shedding ¥600 trillion. Together, assets worth ¥1.5 quadrillion, an amount equivalent to three years' gross domestic product, have evaporated. The ongoing slump brought on by the bursting of the bubble should be recognized as the worst ever in Japan, and probably a once-in-hundred-year slump in the world. (This is not yet apparent to the general population because Japan began the 1990s with sufficient accumulated wealth to postpone the impact of the slump on ordinary citizens.) Banks had loaned aggressively, taking land and stocks as collateral. As one might expect, they are now suffering massive losses. But it is unrealistic to expect banks on their own to clean up the issue of NPLs, a legacy of past lending practices. Japan's land values have fallen by ¥70 to ¥80 trillion every year. Assuming that a mere 10 percent of those amounts are non-performing loans, ¥7 to ¥8 trillion worth of bad assets are generated annually. Given the scale of the ongoing deflationary slump, it is impossible to resolve the NPL problem in two years.

2) Supply-Side Over Capacity must be Adjusted
NPLs are concentrated in the three sectors of construction, retail, and real estate. In the construction sector, there are a total of 560,000 companies including 50 A-rank general contractors, whose sector-wide employment totals 6.5 million, affecting 10 percent of Japan's overall working population (White Paper on Labor). The ratio of those employed in the construction sector is significantly higher in Japan compared to other industrialized nations. (In Britain, 1.14 million people work in the construction sector, accounting for 4 percent of the overall working population.) With demand for public works projects expected to decrease in the years to come, the consolidation of the construction industry is a pressing issue. The problem of excessive debts held by general contractors is not just a creditor-debtor problem. This is an issue related to Japan's industrial revival and must be tackled by setting up a committee on industrial revival under the leadership of Prime Minister Junichiro Koizumi, and by mobilizing the appropriate government agencies - the Financial Services Agency, the Ministry of Economy, Trade and Industry, and the Ministry of Land, Infrastructure and Transport - as well as the expertise of academics and private sector economists, in order to minimize unemployment. For each of the construction, retail, and real estate sectors, a realistic demand curve must be drawn consistent with current macro economic conditions to determine the appropriate size of supply, on the basis of which the elimination of excessive facilities must be promoted. Once the grand design is drawn up by the committee (neither politicians nor bureaucrats should control the selection of companies subjected to a revival scheme), a specific revival plan for each company should be worked out by private-sector experts on corporate revival and consolidation. The assets of companies affected by the scheme should be removed from bank balance sheets and transferred to the Institution for Industrial Revival established under the Program for Financial Revival.

3) Number of Banks must be Reduced
The FSA must tackle the problem of over-banking and reduce the number of banks in Japan. Despite the shrinking economy of the 1990s, loans by private-sector banks began to decrease only in 1998. Due to the over-banking situation, Japanese banks have been unable to secure appropriate returns for risks, keeping bank margins at extremely low levels. Due to the excessive competition among banks, it has often been the case that a company can borrow from a bank at much lower interest rates than it would have to accept through a new issue in the bond market. Further mergers and consolidations within the banking industry will help improve bank interest margins. Such realignment should be accompanied by management overhauls, greater product differentiation, and more customer-oriented services (such as extending bank branch operating hours beyond 3 p.m. and providing weekend services). Bank managers must come up with clear business strategies that enable them to generate profits, even in a deflationary economy. In the non-banking sector, major companies such as Toyota Motor Corp. and Ricoh Co. have continued to churn out net business profits.

In an attempt to accelerate bank disposal of NPLs, the government introduced the tax effect accounting system starting fiscal 1999, allowing banks to report expected future tax returns as deferred tax assets that can be counted as capital. Today, deferred tax assets account for some 40 percent of bank capital. Japanese banks have suffered a steady stream of losses over the past several years, a situation unlikely to change anytime soon. Under current conditions, given the dim prospects that banks will generate taxable income anytime soon, can the tax effect accounting system be justified? Do the deferred tax assets of Japanese banks qualify as assets in any respect? Bank managers and independent bank auditors will face these questions in the next round of shareholder meetings. Shareholders may demand clarification of management responsibility.

Minister Takenaka, who has advocated increased bank corporate governance, should have queried bank managers on these points before bringing up the issue of U.S. standards on tax effect accounting.

4) Capital Funds should be Injected, Even in the Absence of Bank Requests
The managers of the Japanese top banking groups insist that they do not need additional public funds, since the BIS criteria of minimum 8 percent capital adequacy ratio has been cleared. However, it is undeniable that their capital bases are propped up significantly by deferred tax assets, whose qualification as an asset is quite questionable. Bank undercapitalization has been a major factor behind the snail's pace of their NPL disposals. The government should proceed and inject public funds into banks, even when no specific request to do so has been made, in order to accelerate bank disposal of bad loans and to aggressively tackle the issue of excessively debt-ridden companies.

5) New Type of Demand-Boosting Measures must be Implemented
Quite some time has passed since fiscal authorities introduced the zero interest rate policy. Nevertheless, private consumption remains sluggish. Disposal of NPLs is surely important, but the mere disposal of NPLS will not immediately boost consumer demand. In the 1990s, the government formulated 13 supplementary budgets, spending a total of ¥120 trillion on measures designed to stimulate the economy. All those measures have failed to create demand in the long run, instead increasing fiscal deficits. The Japanese people have realized that fiscal policy to temporarily generate demand is meaningless. Instead, what about allocating a certain portion of the government budget for measures to increase population as a way to generate sustainable demand? What about formulating a supplementary budget that focuses on the needs of the younger generation, whose members will shoulder Japan's future? Instead of pumping more money into road construction administration, the government might as well use this money to support child-rearing families, granting one-time subsidies. The birth of children would boost morale at a time when the entire country is sinking ever further into gloom. A growing population will lead to sustainable consumption (Ref. "Shoshika to Nihon-Keizai eno Eikyo (Falling Birth Rate and its Impact on the Japanese Economy by M Fujiwara)").

6) More Economists should be Trained
The FSA and the Ministry of Finance have many specialists on law, fiscal policy, and taxation. But they have very few specialists on economics, finance, and accounting, compared to their counterparts overseas. This may be one reason why Japan's financial reform has been so slow to make progress. There's nothing wrong with hearing what economists at foreign financial institutes have to say. But it is time for Japan to have a home-grown stable of economists and analysts. This should not be such a difficult task for Japan's central government agencies and ministries, which are known to recruit the cream of the nation's elite students.

In the postwar period, Japanese companies leaped forward under the mantra "selling good products at cheap prices." In the 1970s, Japan joined the league of great economic powers. From the 1990s onward, however, Japan has wandered erratically off-course. We often hear senior government officials boast that Japan, despite its stagnant economy, remains the largest creditor country for the United States. However, to rebuild the Japanese economy, the government must make a concerted effort to tackle the NPL problem under the initiative of Prime Minister Koizumi. And in the course of achieving this goal, Japan may have to give up its status as the No. 1 holder of U.S. treasury bonds. But this is a modest sacrifice to pay for the revival of our economy. We must restore our lost confidence and act without undue anxiety about possible reactions from the U.S. Japan must establish a successful business strategy and corporate structures that can survive even in a declining economy - such as those found at Sony Corp. and Canon Inc. - in our financial sector and in other industrial sectors.

November 12, 2002

November 12, 2002