End of Land-Collateralized Loans Era and Beginning of "New" Age of Finance
Amid the continuing severe economic conditions, the swift disposal of nonperforming loans (NPLs) is deemed as the top priority issue for proceeding with economic reform. Without this, it is said that Japan will not be able to restore its impaired financial system and reconstruct the economy. However, will the solving of the NPL problem automatically restore the function and stability of Japan's financial system? Of course not. The presence of NPLs is not the only cause behind drastic changes in the environment surrounding financial institutions. There are other major developments forcing changes in the conventional order of the financial sector, and posing a major challenge to financial institutions, which are: (1) the end of the convoy system of financial administration, and (2) the end of an era characterized by banks' practice of lending on land as collateral.
It should be noted that none of these developments were caused by financial deregulation or temporary economic slump. Instead, they are closely related to drastic changes in the economic structure. For instance, behind Japanese banks' pervasive practice of lending on land was the fact that Japan is scarce in land, and it is an inevitable consequence that land prices go up as capital accumulates. This mechanism, however, has now changed as Japanese manufacturers have begun to transfer their plants overseas, or "import" land from abroad. Today, land no longer functions as an instrument for hoarding value and the era of land-collateralized loans is now over. Also, the continuing fall in land prices - or the value of collateral - has made the government's policy of not letting banks fail under the weight of bad loans economically nonviable. In other words, both the protective financial administration and the banks' practice of lending on land ended because of changes in the economic structure.
For Japan's financial sector to continue to fulfill its function in this new environment, banks must strive, more than ever, to enhance their capability of assessing the true ability of corporate borrowers (screening capability) so that they do not have to rely on collaterals when making lending decisions. Reality, however, is moving in the opposite direction. As shown in the attached chart (click here), the presence of guarantee by a credit guarantee association, along with respective borrower's ability to repay, serves as a key factor when banks decide on lending to small and medium enterprises (SMEs). This coincides with changes in the profile of bank loans over the 10 years subsequent to the burst of the economic bubble, in which land-collateralized loans in proportion to overall loans decreased (from 28.4 percent in fiscal 1992 to 20.9 percent in 2001) and guaranteed loans increased (from 29.7 percent to 38.9 percent during the same period). Ironically, the end of the era of land-collateralized loans seems to have ushered in this "new" era of, "loans guaranteed by credit guarantee associations."
How to Overcome the Difficulty of Assessing SMEs in Lending Decisions
How can banks diagnose potential corporate borrowers? It must be noted that the assessment of SMEs for their true ability involves a range of difficulties which banks would not encounter in lending to major companies. The performance of SMEs varies widely from one company to another, and their capability is often determined by, "factors hard to define in numerical terms," such characteristics of the founder of a company. In other words, in lending to SMEs, banks need to overcome assessment difficulties concerning the varying performances attributable to non-numerical factors.
As a means to make such, "hard-to-see factors," more visible, an idea called 'relationship banking' which focuses on lender-borrower relationships, is gathering attention. If a bank and its corporate borrowers manage to formulate solid relationships through steady communication and information exchange, the bank would be able to consider non-numerable factors - such as, "high morale among employees," and the, "leadership of the president," - in its lending decision, which in return would enable smoother financing. Also, relationship banking incorporates various kinds of information other than objective numerical factors in making lending decisions, thus enabling a greater variety of lending schemes that can meet the needs of respective borrowers.
But banks' efforts alone cannot build such solid relationships. SMEs must make positive efforts, too, to disclose more information to their lender banks concerning the state of business and future strategies. At the moment, roughly half of SMEs with 20 or less employees do little more than submit financial statements and other relevant materials to their main bank. Under such circumstances, banks would not be able to make lending decisions based on the potential of a borrower. This is something that SMEs must reflect on themselves towards formulating solid relationships with their lender banks.
Responses to Ongoing Financial Problems and Emergence of New Players
In developed countries other than Japan, the idea of relationship banking is widely accepted by those studying corporate finance. In Japan, however, the idea seems to be unwelcome. Moreover, in reality the situation is moving in the other direction with emphasis increasingly placed on financial data, and other easy-to-numerlicalize information, in measuring companies. The more standardized the measure of a sound company becomes, with judgment made almost solely on the financial aspects, the more uniform become banks' behavior, regardless of how many banks exist. The result would be the concentration of lenders' money on a handful of financially-sound companies and excessive competition among financial institutions.
In yet another annoying development, mergers and consolidation are proceeding within the banking sector in such a way as to solve the 'excessive' competition. According to studies conducted in the United States and Europe, a merger - due to increased organizational complexity as its inevitable consequence - tends to impair the communication of corporate information that cannot be categorized into a conventional format. Therefore, a merger between or among financial institutions may break otherwise solid lender-borrower relationships. In addition, diversity among component banks in their approach to SMEs would be lost when their assessment standards are integrated as one merged bank. Analysis conducted for this white paper has also found that SMEs have experienced greater difficulty borrowing after their main bank has merged with other financial institutions.
As such, the ongoing development in the Japanese financial sector is that of moving towards a financial system in which lender-borrower relationships collapse and a small number of financial institutions offering uniform services try to lend money to a handful of borrowers, thereby causing competition resembling that seen under 'over banking'. How can we escape this situation?
One clue to breaking this impasse may be provided by the facilitation of credit granting among companies doing business with each other. In the previous financial slump, for instance, some manufacturers, construction companies, and trading houses provided finance for SMEs with which they had business relationships. This kind of corporate-to-corporate financing can be defined as an extension of relationship banking in that credit granting from a lending company to a borrowing company is underpinned by actual transactions between them, and that the former takes hold of non-formulaic information about the later, for instance, its technological level.
Corporate-to-corporate credit granting also suggests what it takes to restore SME financing. What exists in corporate-to-corporate credit granting, but does not in credit granting by banks, is detailed knowledge about the borrowing companies' technology and the real economy surrounding the industry they belong to.
Banks, for their part, must properly digest corporate information they obtained through relationship banking based on their detailed knowledge of the real economy. In restoring the financial system, it must be firmly recognized that the presence of financial institutions with varying views, in line with the diversity of SMEs, is the key to realizing a sound SME financing system.
