A Clear Line Must be Drawn Between "Regional Revitalization" and Banking Administration: Assessment of the "Financial Function Reinforcement Law"

TSURU Kotaro
Senior Fellow, RIETI

A new law to reinforce the function of Japan's financial system was enacted in the last regular session of the Diet. The financial function reinforcement law, enacted on June 14, has paved the way to allow the government to inject public funds to revamp the capital base of a healthy bank as a step to preempt a possible financial crisis. The new legislation is meant to offer public funds as dangling carrots to promote further realignment of the financial sector thereby dispelling any public anxiety over financial instability ahead of the full introduction of the "payoff" limited deposit protection system in April 2005. The regulatory authorities aim to accelerate mergers and other realignment moves especially among local financial institutions - first-tier and second-tier regional banks, "shinkin" banks and credit cooperatives - that are lagging behind major banks in disposal of nonperforming loans (NPLs) and restoration of the soundness of overall business operations. Although the application of the law to major banks is not ruled out, it is obvious that local financial institutions are the prime target of the new public fund injection scheme. For one thing, the government has set aside a budget of only ¥2 trillion for public fund injections in fiscal 2004. And another, the law stipulates that to be eligible for public fund injection, a bank must be indispensable for the local economy and that the reinforcement of the bank must contribute to the revitalization of the local economy.

To what extent the financial administration is to play a role in revitalizing local economy, however, is not necessarily prima facie evident. I am afraid that the prevailing atmosphere may be one in which any policy would be politically justified as long as it advocates for the revitalization of a stumbling local economy. Ever since the public fund injections into Resona Bank and Ashikaga Bank, consideration of impacts on local economies has become a prime factor in deciding financial administration policies. In this column, I would like to critically examine the financial function reinforcement law, focusing on the relationship between financial administration and local economies.

Public fund injection to Resona Bank and its "unintended Keynesian pump-priming effect"

Article 102 of the Deposit Insurance Law was cited as a legal basis for public fund injections into Resona Bank and Ashikaga Bank last year. The law stipulates that public funds can be infused into a bank's capital base only after the bank is judged to be on the brink of a financial crisis or when "it is feared that its condition may pose a significant impediment to maintaining the credibility of the financial system." Thus, the possibility has been left out that a financial crisis may materialize before completing due necessary procedures including the meeting of the Financial System Management Council headed by the prime minister. As such, equipped only with the recapitalization scheme under Article 102 of the Deposit Insurance Law, the financial regulatory authorities must have been feeling like they were "walking on a tight rope" and longing for the establishment of a system that explicitly permits the crisis-preventive infusion of public funds (even into sound banks). Actually, in handling the case of Resona Bank, the regulatory authorities ventured to deviate from the scope of the recapitalization scheme under the Deposit Insurance Law, deciding on the use of public funds in a way that would avert a possible financial crisis.

As it turned out, however, things began to move forward following the government's decision in May last year on the public fund injection into Resona Bank. Stock prices bottomed out and have begun to rise rapidly. And this, coupled with the steady recovery of real economy, has been helping major banks to improve business performance and quicken the disposal of NPLs, whereby the fear about a financial crisis - the very reason behind the injection of public funds - has begun to fade away. What is interesting here is that the public fund infusion into Resona Bank played a role equivalent to that of Keynesian fiscal policy. That is, the government's firm commitment to solving bank problems - demonstrated in the form of public fund infusion - has won appreciation of market players, which has led to the restabilization of bank shares, thereby improving overall market confidence and pushing up stock prices. Meanwhile, such recovery and restabilization of stock market have brought about a "pump-priming" effect to put the whole economy back on the track to steady recovery. To be sure, the public fund injection into Resona Bank was problematic as a financial administrative step, lacking an explicit legal basis and running the risk of encouraging moral hazard by creating the anticipation that the government would rescue a bank in the end. Yet, in hindsight, this problematic decision by the government served as an "unintended Keynesian policy."

Problems besetting local financial institutions: Surfacing of demerits of "relationship banking"

Major financial institutions - those operating nationwide - tend to benefit directly from the recovery of the macroeconomy. But such is not the case for local players that are strongly affected by the respective local economies where they operate. Thus, the problem of fragile local financial institutions must be addressed ahead of the full implementation of the payoff system next April. "Relationship banking," which is to provide loans and other financial services based on the continuous and close long-term relationship between a bank and its customers, has long been the basic model of local financial institutions. The NPL problem besetting these local financial institutions today can be comprehended as the exteriorization of the demerits of such long-standing relationship banking.

More specifically, local financial institutions have continued to lend to inefficient borrowers because of the long-term relationships and community-based trust with the structurally-depressed local industry and companies. This problem of "soft budget constraints" or "forbearance lending" has resulted in the build up of NPLs and eroded the financial health of local financial institutions.

Reshuffling of the lender-borrower combinations through enhanced competition

The financial regulatory authorities have been calling for strengthening the function of relationship banking. However, in order to solve the aforementioned problem, it is necessary to reshuffle the existing lender-borrower combinations by first restoring their relationship to neutrality - or keeping an appropriate distance between lenders and barrowers - and then dissolving ineffective relationships.

Through this process, incompetent players - corporate borrowers and lenders that are doomed to fail - would be sorted out, while new "relationship banking" would emerge between sound financial institutions and promising borrowers. To realize financial and management reconstruction of local financial institutions, it is first and foremost important to have their assets assessed against strict criteria, which are equivalent to those applied to major banks, so as to accelerate the disposal of NPLs and strengthen governance. It is not appropriate to unnecessarily stress the peculiarities of local financial institutions.

The regulatory authorities must not try to extend the life of a moribund financial institution out of fear of the negative impact of its failure on the local economy. What is more important is to create a competitive environment where even if one financial institution falls out, a new substitute player would come in and provide new "relationship banking" services. In this regard, a situation where a specific financial institution has a dominant presence in the local economy is undesirable from the viewpoint of financial administration. Under such a situation, both the lender and borrowers would find it difficult to diversify risks and the demerits of relationship banking would be more apt to surface. As is the case with typical "keiretsu" supplier-buyer relationships in Japan, competition among service providers - even if limited in number - is an important factor in any continuous long-term relationships.

Deficiencies of the scheme under the financial function reinforcement law

In view of factors discussed above, how can we evaluate the financial function reinforcement law that has been just enacted? Among relatively large local financial institutions, there are some whose operations the regulatory authorities should step in to reconstruct before they fall into a critical condition, using public fund injections as leverage to force them accept painful measures. The financial function reinforcement law offers an important scheme to achieve that end. But I would like to point to two problematic aspects of the new law.

First of all, it is questionable whether mergers and other realignment moves by local financial institutions would bring benefits to the extent where it is justifiable to give them a dangling carrot - public fund injection without clarifying the responsibility for failed management - for the sake of overcoming the weakness of local financial institutions. Indeed, in a merger between a strong bank and a weak one, it would be clear which one is to supervise governance and subsequent restructuring would go smoothly. However, a merger between two weak banks is prone to suffer from conflicts between different corporate culture and it would be extremely difficult to generate synergy. Meanwhile, a series of recent theories and empirical studies have shown that smaller financial institutions are more advantageous in obtaining and utilizing "soft information" about borrowers, which is a key factor in providing "relationship banking" services. In other words, a relatively large local financial institution, created by a merger between two small banks, may find it more difficult to extend loans and other finely-tuned services to small and medium-sized enterprises (SMEs) than it used to be to do so as two separate banks. Furthermore, there also exists the risk that such a merger may result in a regional monopoly. Considering all the above, it would not be unreasonable to suspect that the government is trying to promote mergers between or among small financial institutions to make them "too big to fail" as a means to assure depositors of the safety of their money ahead of the full implementation of the payoff scheme. Should this be the case, however, such a government policy is nothing but a complete anachronism. It is as if hearing, all of a sudden, the once all-too-familiar chocolate commercial song of the late 1960s, in which the late composer Naozumi Yamamoto was singing "big is good" in his big voice and with a big gesture. (The song in the commercial praising the enlarged size of the chocolate bar was reflective of people's sentiment at that time, when Japan was in the midst of the high growth period.)

The second problem with the new law is that the effect of revitalizing a bank and the sheer size of the bank's presence within the local economy are included in the criteria for judging the eligibility for public fund injection. However, there are only a few - if any - economic theories which would support arguments calling for extending the life of a specific financial institution, even with government involvement, based on the reason that the failure of the institution would deal a significant blow to the local economy. Rather, there exists a firm theoretical foundation - negative externality - for subjecting financial institutions to regulations stricter than those for nonfinancial companies. That is, a bank failure - unlike the failure of a nonfinancial company - may cause extensive chain reactions with negative impacts spreading through the payment system to other financial institutions and their corporate customers, including those under sound management. Therefore, the degree and spread of such negative impact should be a criterion to judge whether the government should implement restrictions or intervene.

A local financial institution engaged in "relationship banking," even if small in scale, has very close relations with borrowers in its local operating areas and therefore its failure would have a devastating impact on local businesses. Although geographical areas affected may be limited in scope, borrowers are concentrated in these limited areas and the impact felt by each of them would be very acute. Though this is an extreme argument, if too much emphasis is placed on the impact on local economies, the government may have to rescue even the smallest local financial institution. As discussed earlier, the reshuffling and then recombining of lenders and borrowers in "relationship banking" are key to solving the problems of local financial institutions. This transitional process may bring a sizable negative impact on local economies. Without such reshuffling and recombination, however, there will be no reviving of local economies. Therefore, as a short-term goal in financial administration, the government should focus on restoring the soundness of local financial institutions rather than broadening policy targets to include the revitalization of local economies. Financial administration must draw a clear line and keep away from policies to protect vested interests which would justify any pork-barrel spending under the banner of regional revitalization.

July 6, 2004

July 6, 2004