A Perspective on the Type of Financial Regulation Needed to Strengthen Local Financial Institutions: "Numerical Targets" Versus "Evaluation System"

TSURU Kotaro
Senior Fellow, RIETI

On March 29, 2005, the government unveiled its new "Action Program for Ensuring Further Promotion of Region-based Relationship Banking," which set forth an administrative policy on local financial institutions for two years starting in fiscal 2005. The action program, drawn up in accordance with the Program for Further Financial Reform announced in December 2004, calls on local financial institutions to develop and publish a "relationship banking promotion plan" by the end of August 2005 aimed at 1) business recovery and facilitation of small- and medium-sized enterprise (SME) financing, 2) strengthening of management functions, and 3) enhanced convenience for local customers. A notable part of the new program is language urging local financial institutions to voluntarily set and disclose "specific and easy-to-understand targets, including numerical targets" as part of their plans. The possibility of setting numerical targets for the management of local financial institutions was discussed at the Council on Economic and Fiscal Policy last year when it developed the Program for Further Financial Reform. The council, however, decided not to refer to numerical targets in the program in view of the diversity of local financial institutions. To those familiar with the background of how the program was drawn up, the reference to numerical targets in the new action program must have come as a surprise. In this column, I would like to discuss the pros and cons of the setting of numerical targets by local financial institutions. I will then try to identify desirable financial regulatory measures vis-a-vis local financial institutions, in particular, how to make good use of the proposed "evaluation system" currently under study at the Financial Services Agency.

Commitment to numerical targets must be based on self-discipline by financial institutions

In setting numerical targets for financial institutions, regulatory authorities can either impose specific numerical targets for universal application, or let each financial institution set its own targets. Halving the ratio of nonperforming loans (NPLs) to total outstanding loans, a uniform target imposed on major banks in the past two years, is an example of the first type. On the other hand, the voluntary setting of numerical targets by each local financial institution, called for in the new action program, is an example of the second type. In this case, the emphasis is on the setting of numerical targets voluntarily by the management of each financial institution. These targets are defined as a means of gaining customers' understanding of the institution's future goals, rather than a commitment to regulatory authorities.

The imposition of a uniform target for major banks to halve the NPL ratio, which was part of a package of policy measures, has turned out to be a success: The banks appear certain to meet the target. However, this success owes much to the fact that the target was imposed on a limited number of financial institutions that are relatively similar in their business scope, management conditions and so forth. In other words, these major banks have been able to aim at a uniform target because the disposal of NPLs has been the paramount objective for all of them. Also, because the number of banks subject to the target was limited, it was relatively easy to monitor each bank's progress in achieving the target as compared to others, thereby creating effective and positive peer pressure. On the other hand, the diversity of local financial institutions, including regional banks, shinkin (cooperative) banks and credit cooperatives, in addition to their sheer number, makes it is difficult to impose uniform numerical targets on all of them. Moreover, should too many of these financial institutions fail to achieve the targets, individual failures would be less conspicuous; positive peer pressure might not work properly. In this sense, the government's decision not to subject local financial institutions to the same target of halving the NPL ratio applied to major banks was appropriate.

Meanwhile, how should we assess the government's urging of local financial institutions to set voluntary numerical targets? Such targets have been defined not as a commitment to regulators, but as a commitment to customers. That is, each financial institution is to set its own target for the purpose of securing customers' trust, as well as to enable customers to evaluate its performance. Ideally, financial institutions, being fully aware of the importance of discipline through information disclosure, would commit themselves to achieving such voluntary targets. However, when this is done under government guidance, those indifferent to self-discipline would likely commit themselves only to targets that can be achieved with absolute certainty. Such mandatory target setting may undermine rather than bolster customers' confidence. Another point of concern is the possibility that "voluntary" targets, despite being defined as a commitment to customers, may be used as a tool for discretionary regulation. Quite a few local financial institutions seem flustered by the idea of setting, albeit voluntarily, numerical targets. They may seek advice from the financial regulators, which would render meaningless the idea that such targets are "voluntary initiatives" taken by individual financial institutions. Furthermore, this approach, whereby each financial institution sets a voluntary numerical target upon which it is evaluated, is fraught with the same problems seen with a performance-oriented employee evaluation system: Setting a numerical target is difficult. And it is uncertain whether institutions would be evaluated solely on the extent to which they have achieved the target. All these factors would weaken commitment to the targets.

As I have discussed in earlier articles published on this website (see note), a major problem with Japan's financial regulation is that the government continues to shelter local financial institutions. It has continued to dangle carrots in front of local financial institutions while wielding sticks against major banks. Two years ago, when the government was drawing up the Program for Financial Revival, local financial institutions must have been bracing themselves in anticipation of strict policy measures. As it turned out, the government drew a clear line between them and the major banks, applying a "moratorium policy" to urge local financial institutions to further strengthen their relationship banking functions. Relationship banking is an area that local financial institutions have been focusing on for some time. Reinforcing such functions was thus not very demanding. Had they been subjected to the stricter measures applied to major banks, many local financial institutions would have restored sound management by now. It is quite possible that the government's "carrot" policy has made individual financial institutions less willing to improve management on their own initiative. In this respect, the government's approach to local financial institutions is similar to its agricultural policy, under which regulatory protections have long deprived individual farmers of the opportunity to differentiate themselves from others and demonstrate originality and ingenuity so as to finally become independent.

Policy measures for local financial institutions: Making good use of the evaluation system

What then, would be a desirable policy response to the problem of local financial institutions? One clue can be found in the proposed "evaluation system" under which each financial institution would be rated by the regulatory authorities. The evaluation system, included in the Program for Further Financial Reform, is currently under review by a study group at the FSA. Indeed, some local financial institutions are sound and highly profitable, developing and cashing in on their own unique business models. At the same time, however, many others have been slow to improve management and to resolve their NPL problems. As such, there are growing differences among local financial institutions. This situation definitely calls for selective regulatory measures. For a long time, this has not been a viable option for the government as the nation's financial system remained weak and fragile: It feared any attempt to implement policy measures targeted at specific financial institutions would have a signaling effect, thereby giving rise to reputational and systemic risks. But the situation has changed and financial regulators are now being urged to switch from a crisis mode to a normal mode. The government should thus be ready to make distinctions among local financial institutions. For instance, regulators should change the frequency and scope of inspections based on an evaluation of each financial institution. Such a measure is indispensable if Japan is to restore the soundness of local financial institutions within the next two years by economizing its limited administrative resources.

One particular point that needs to be studied in implementing the evaluation system is how to incorporate the concept of relative evaluation into the system. To be sure, ratings assigned to each financial institution - both of its overall performance and with respect to individual evaluation criteria - are given in absolute terms and there will be no change in that regard. However, in order to make evaluations work as an incentive for financial institutions to improve performance - just as grades are for students - each institution should be able to determine its position relative to its peers. This is all the more important given the trend among local financial institutions toward oligopoly and reduced competition. One regulatory approach toward public utilities, which tend to enjoy regional monopolies, is to compare one utility's performance with that of similar utilities operating in other areas and use the results of such relative performance evaluations as a source of information in regulating the industry. This "yardstick competition" scheme is found in the water and electricity sectors in Britain, for example. A similar framework should be established for local financial institutions in Japan so that each can make objective assessments of their own capabilities while learning from the successes and failures of their peers. I believe that the creation of such a framework will motivate financial institutions to improve their management on their own.

May 2, 2005

May 2, 2005

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