The Dilemma Facing Financial Policy: The Merits and Demerits of Signaling
Senior Fellow, RIETI
With the sharp drop in stock prices since September that has brought the bellwether Nikkei average to record post-bubble lows, concerns are once again mounting over non-performing loans and the stability of the banking sector. Although the seriousness of the issue over the past few years has not abated - if anything, growing in magnitude - it has more or less been forgotten during times of relatively stable stock prices, as if the problem had been solved. For whatever reason, the issue of financial stability raises its head whenever stock prices fall or when companies close their books. This is similar to a situation where people standing in a pool (banks) are fine when the water level only comes up to their necks, but begin shouting for help if the water rises any further. Such scenes may appear comical from the sidelines. But for the parties concerned, rising water levels spell catastrophe.
The difference this time around is the Bank of Japan' s Sept. 18 announcement that it would buy bank shareholdings, a policy with an air of desperation about it. Furthermore, in the Cabinet reshuffle at the end of September, the reins of financial policy were handed from Hakuo Yanagisawa, who was said to be reluctant to inject public funds into banks, to Heizo Takenaka, who is believed to see such a move as a viable option. These developments point to a possible about-face in financial policy. Whether regulators use or abuse what is most likely their last opportunity to settle the bad loan issue once and for all hinges on their willingness to review the dilemmas faced by past financial administrations, and their mistakes. In this column, I would like to examine this issue from the viewpoint of the effects of "policy signaling."
Assessment of the Bank of Japan's proposal to purchase bank shareholdings
The Bank of Japan's announcement that it would buy shares held by banks was met by surprise from market players. Some within the government and the ruling coalition sharply criticized the move, as did some foreign media. The announcement certainly left us with the impression that the central bank had made a hurried about-face, since the BOJ up to that time had adamantly rejected calls to boost liquidity and ease monetary policy by purchasing relatively high-risk assets. The BOJ had argued that this was impossible, as there was no way to make up for any capital loss incurred from such assets, and that doing so would greatly undermine confidence in the yen. For its part, the BOJ likely believes that while concerns over the capital loss issue remain, this new policy does not necessarily conflict with its past stance, because it is an unusual, one-time-only step that does not seek to promote greater liquidity or shore up stock prices, but solely encourages banks to shed their shareholdings and reduce their exposure to stock price fluctuation risks, which can greatly destabilize their management. Moderation and discipline are clearly important for both financial policy or fiscal policy. However, this does not support instituting taboos in economic policy. In the event of drastic changes in economic circumstances, there will naturally be a need to implement bold policies, while remaining fully aware of the potential disadvantages of such policies. In other words, the appropriateness and desirability of a certain policy depends on specific economic conditions. Whatever the objective of the move, the central bank's purchase of bank assets should be considered as part of a continuous chain of events brought about by changes in economic conditions. Oddly enough, it may be said that on this occasion the BOJ itself proved that this holds true.
As for the purchase of bank shareholdings, details of the scheme were released on Oct. 11. While it premature to assess this policy, I would like to point out two major implications. First, using policy measures to reduce bank shareholdings may be the start of a major turnaround in the financial system itself, as we saw in the United States after the Great Depression, when the Glass-Steagall Act was established to prohibit commercial banks from holding shares, after scandals involving certain banks (among them JP Morgan) that had exerted strong influence over companies as shareholders. A decline in bank shareholdings signifies the end of the so-called "main bank model," in which corporate governance is enhanced and made more effective by having the bank serve as both a creditor and a shareholder.
Even more important than the policy itself is the signal it gives. The BOJ, which conducts its own inspections of banks independently from probes carried out by the Financial Services Agency, is in a position to have full awareness of how banks are faring. However, if the central bank were simply to disclose the wretched state of these financial institutions, a financial crisis might ensue. Instead, for the BOJ, which is privy to the internal situation of banks, deciding to implement a policy regarded as financial anathema despite a full awareness of the attendant risks and potential criticism, the new policy played a key role in sending a credible signal to the general public that the deterioration of the banking sector's capital bases and the instability stemming from this situation had reached crisis levels. In fact, we can see the BOJ's strong resolve regarding non-performing loans in its paper on the issue released Oct. 11. In this document, the central bank - which had long refrained from tackling the bad loan problem head-on despite recognizing its importance due to concerns about meddling in matters beyond its jurisdiction - outlines its willingness to act as the lender of last resort in times of crisis, and at the same time urges (the government) to consider injecting public funds into banks as a policy option.
Discussions of the credibility of such economic policies are also seen in the arena called the "political economy of reform." (Sturzenegger and Tommasi (1998)) According to this argument, putting forward reforms that run counter to a policymaker's position increases the credibility of his or her policies. One example is the case in which a populist government suggests the implementation of market-oriented reforms. Even though such a move may erode that government's political base and draw fire from ruling party lawmakers, it also underscores the painful necessity of such reforms and the critical state of the economy, thereby increasing the credibility of the proposed reforms. (For example, John Williamson and others at the Institute for International Economics in Washington conducted a case study which showed that of 13 countries that implemented market-oriented reforms, only three had rightist governments. The rest were leftist. (Williamson (1994))
The injection of public funds and its signaling effect
On the other hand, with the removal of a financial services minister who denied the precarious condition of the banking system, the government, through a strategic project team on financial affairs headed by Minister Takenaka, is also poised to draw up an action plan. According to media reports, Takenaka has stressed the importance of three principles: (1) stricter asset assessment; (2) improved capital bases; and (3) better governance when utilizing public funds to accelerate the process of bad loan disposal. As mentioned by the BOJ in its paper on the non-performing loan issue, there is probably no room for argument regarding the importance of more rigorous evaluations of loans and examination of the procedures by which loan-loss reserves are established to better reflect reality. However, unless we reconsider why such moves were never fully implemented in the past despite recognition of their importance, we are likely simply to repeat these mistakes.
The essence of the problem is that financial administration in Japan is based on the premise that banks should not be allowed to fail. Such a tacit understanding clearly leads to lax assessments by both financial authorities and the banks themselves with respect to problem loans. Such a premise also leads to loan-loss reserves based primarily on the inclinations of a particular bank.
Why not permit banks to fail? This is not unrelated to the somewhat unique situation in Japan. Under a bad loan disposal framework based on normal bank supervision and banking theory, banks whose capital are at such low levels as to merit liquidation account for only a small portion of the entire financial system. However, in Japan, the collapse of the asset-inflated bubble economy dealt a serious blow to practically all financial institutions. As regulators grappled with the problem of there being "too many (banks) to fail," (the large numbers of banks susceptible to failure,) the situation continued to deteriorate as industry restructuring led to the creation of four major banking groups, thereby rendering banks "too big to fail." There is no doubt that the government and ruling coalition parties fear that a great many banks in Japan will become capital-short if active bad loan disposal is pursued. Due to the associated scale, the possibility of financial crisis or systemic risk is much greater than in other countries, where bad loan problems have already been settled. No politician wants to be remembered as the individual who triggered a global depression. But at the same time, we also need to reconsider whether the failure of a bank with negative net worth would really lead to massive financial panic and systemic risk. Even if financial and settlements systems, which are part of a global network, are held hostage by the banking industry, authorities should demonstrate their determination to encourage banks of negative net worth to fold their tents and make a graceful exit.
I say this because only when regulators can determine which financial institutions are to fail can we seriously discuss the issue of whether to inject public funds into banks. Public funds should only be used to recapitalize banks that are fundamentally viable, despite being capital-short at the present, not banks that have already fallen into the territory of negative net worth. However, such a capital injection poses two dilemmas. The first is the issue of the responsibility of bank management and financial regulators. If public funds are injected into banks, financial authorities and top management at those banks will be called upon to shoulder some form of responsibility. But because neither party wishes to do so, more often than not, they will simply maintain that "public funds are unnecessary." In other words, this is a dilemma in which the banks that most need public funds reject capitalization offers. Some form of mechanism must be established that transcends both the industry and regulators and can forcibly infuse public money into banks.
The other dilemma is that the public fund injection itself may serve as a signal. To receive public funds, a bank must present details of its capital base after rigorously assessing its loans and making the appropriate allowances, or selling off loans at loss-incurring prices. This means that the amount of public funds needed for recapitalization will vary from bank to bank. But the market may turn on a bank (a sudden drop in stock price, confusion in the interbank market), or depositors might make a run on a bank if the contents of its balance sheets differ from market perceptions. Even if such information were not disclosed and only the amount of public funds injected made public, so long as those figures accurately reflect actual capital levels, they effectively become signals that reflect bank balance sheets. Thus, when the figures for public funds injected into individual banks are revealed, the same potential remains for same confusion among markets and depositors. Under these conditions, the appropriate policy for the situation may send a signal that triggers a financial crisis. Banks received injections of public funds on two previous occasions: In March 1998, all major banks received 100 billion yen. The infusion amounts varied more in March 1999, but when the figures are recalculated based on the scale of bank assets, there was very little difference in the amount received by each of the major banks, except that the former Fuji and Daiwa banks received a little more than the others, while the former Sumitomo Bank received slightly less. Excessive concern for the potential effects of injecting appropriate amounts of public funds inevitably results in even-handed distribution of funds in amounts too small to have significant effect. However, if authorities continue to make these small, uniform capital injections, it will only serve to magnify the magnitude of the resulting signal once they actually determine to inject public funds in amounts that reflect the realities facing the banks.
Now is the time to seriously discuss how these two dilemmas can be overcome. Banks that ought to fail should be permitted to do so. If the harmful repercussions of their collapse threatens the operations of healthy banks, the BOJ should intervene as the "lender of last resort." In addition, to minimize the effects of signaling, the comprehensive disposal of non-performing loans should be carried out in tandem with public fund injections, and this must be a compulsory, one-time-only act. This represents a major procedure on which the very life of Japan's financial system may depend.
* Originally published in Economics Review (Japanese) on October 17, 2002
October 17, 2002
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