Japan's Financial System in the Future

Takeo Hoshi

Five regimes of the development of Japan's financial system

I would like to talk about the future of the Japanese financial system based on "Corporate Financing and Governance in Japan: The Road to the Future," which I authored in collaboration with Anil Kashyap.

About three years ago when I started research for this book, I thought the problem of bad loans would be solved in due time so I was doing research on a new financial system which should be in place after the completion of the bad loan problems. As it turned out, however, we have yet to overcome the bad loan problems.

In the book, I tried to analyze, in the light of economics theory, the development of the Japanese financial system in the 150 years since the Meiji Era, defining significant changes as results of government interventions, huge external shocks and subsequent reactions from the private sector. I tried to answer four key questions:

1. How do Japanese households hold their financial assets? Do they keep such assets in the form of bank deposits, stocks or bonds?
2. How do Japanese companies raise fund?
3. What kind of financial services do Japanese banks provide and what kinds of role do they play?
4. What is the structure of corporate governance within Japanese companies and what kinds of roles do Japanese banks play in corporate governance?

The development of the Japanese financial system can be divided into five regimes. The first regime is a burgeoning period till around 1937, during which there were few restrictions and direct financing through stock issuance played a significant role. The second regime is wartime and subsequent period under occupation. This period saw the strengthening of regulations and the beginning of indirect financing through banks. The third regime is the golden age of Japan's postwar system in which banks played a leading role in corporate financing. The fourth regime is from the late 1970s to 1997 when deregulation proceeded and companies shifted to direct financing. The fifth regime is the post-Big Bang period which has seen the completion of deregulation and the establishment of a market-oriented financial system. In a sense, the Japanese financial system is now returning to a system similar to the one in the burgeoning period.

The Financial System in the 21st Century

My conclusion as to how the Japanese financial system will evolve in the 21st century is this. First, the portion of bank deposits within household financial assets will decline while that of securities investment, including those in the form of investment trust, will go up. Companies, except for small ones, will increase their dependence on capital markets for financing. Major banks will aim to become a universal while smaller ones will try to find niche and concentrate on traditional banking services. Banks' role in corporate governance will recede with shareholders expected to increase their influence.

There are three reasons for reaching that conclusion. First, the convergence of financial regulations is now taking place in a global scale. In Europe, too, financial markets are now playing greater role than banks in corporate financing. Second, we see little difference between financing activities of Japanese major companies and those of their U.S. counterparts. At least partly, a shift to market-oriented system is already taking place. Third, Japan's financial system was originally "market-oriented" before regulations were strengthened in the second regime.

The Big Bang reform surely triggered a shift toward a new financial system. But such a financial liberalization did not occur overnight and it is more appropriate to define the Big Bang as the final stage of financial reform that began in the late 1970s. By analyzing the gradual liberalization hitherto implemented, we can predict what kind of financial system will emerge in the 21st century. For more details, please refer to Hoshi and Kashyap "The Japanese Banking Crisis" NBER Macroeconomic Annual 1999.

In the pre-liberalization period, there was a situation in which companies had no choice but rely on banks for financing. Japanese households had no alternative forms of saving money other than bank deposits and postal saving. And banks inevitably concentrated on the traditional banking services of collecting deposits and lending.

Liberalization began in the last half of the 1970s. Major companies began to shift to equity financing in the early 1980s, decreasing their reliance on banks. But options for household investments remained limited. With walls between the banking and other financial sectors kept intact, Japanese banks continued to concentrate on the traditional business.

Where Is the Japanese Financial System Heading For?

So, what was the result of such incomplete and slow liberalization? Major companies had completely shifted from banks to capital markets by around 1990 but this did not force Japanese banks to shrink their business. Deposits continued to flow into banks. But banks coped with this by lending to small- and midsize companies, especially expanding loans related to land. This evolved into huge bad loan problems in the 1990s.

Where is the Japanese financial system heading for? I believe a system similar to the one in the United States will emerge after the bad loan problems are thoroughly solved. Financial regulations similar to those in the U.S. are now being implemented and more Japanese companies are adopting U.S.-style financing. Some people may feel more like returning to the postwar system when Japan had a market-oriented financial system.

Now, let me show you a chart on major manufacturers dependency on bank financing. The original data were taken from the Finance Ministry's Business Outlook Survey. When we compare Japanese and U.S. major companies' dependence on bank loans, we do not see much difference except for the oil, coal and steel industries in which Japanese firms show conspicuously high dependency on bank loans. About small- and midsize companies, situations are different.

This Americanization of Japanese major companies' financing activities will mean the shrinking - by 20 to 40 percent according to some estimate - of the Japanese banking sector, at least of the traditional banking business. Banks will likely suffer substantial falls in assets and consolidations hitherto carried out are not sufficient to cope with the changing situation. Thus, realignment of the banking sector is expected to continue.

Given such prospects, banks have two options. The first option is to evolve into a universal bank to provide "one stop shopping" services, a bank in which individual customers can deposit, buy trust fund and so on. The second choice is to take niche strategy, for instance, concentrating on traditional banking services for individuals or small- and midsize companies. With either of those options, banks will have a chance to succeed. With it will be more difficult to succeed in universal banking because banks need to win fierce cross-border and cross-sector competitions.

Let me talk about investment activities of Japanese households. Although the Big Bang reform has expanded investment options for households, we have yet to see clear evidence for changes in their actual investment activities. The ratio of bank deposits vis-a-vis overall household financial assets has not decreased and investment in securities is showing only a gradual increase.

As of the end of March 2001, bank deposits represented only 15 percent of overall household financial assets in the U.S. with the ratio of market-related financial on the rise. In contrast, cash and bank deposits account for more than 50 percent in Japan. Thus, for the moment, Japanese household has yet to shift to a market-oriented investment activities and it will take a while for such a change to occur. Still, even a small change may lead to a fairly big change to household investment activities. As to corporate governance, I expect major changes. In the 1990s, the role of the so-called main banks declined with no entities taking over the supervising role from them, creating a vacuum. However, shareholders are now beginning to fill that vacuum, as seen in the dissolution of cross-holding of shares, the increasing number of lawsuits brought by shareholders, and the growing presence of individual and foreign institutional investors. Also, a series of polls show that more and more business managers are putting greater emphasis on shareholders' benefits.

From historical point of view, a shift to a market-oriented financial system is a return to the pre-war system. In the prewar system, equity and other capital markets played a greater role and a greater portion of financial assets were held in the form of securities. Corporate governance led by shareholders was functioning to a certain extent. In the household financial assets, securities accounted for greater portion than now. Direct financing from capital markets through the issuance of stocks and bonds represented a major portion of overall corporate financing.

In the prewar period, stock markets - not only the Tokyo Stock Exchange but also the Osaka Securities Exchange - were big in scale. The aggregated value of the markets in 1936 was roughly twice that of 1998 in terms of its ratio against gross domestic products.

In conclusion, it is wrong to say market-oriented financial system dose not fit for Japan. The so-called "Japanese type" financial system is nothing but the product of wartime and postwar regulations. Now that regulations are removed, it is quite natural for Japan to go back to the market-oriented system

Yuko Kawamoto

I quite agree with the view that financial system is affected by regulations. In the prewar period, Japan had many inefficient banks and they were forced out of market as the market theory was then functioning properly.

In many other countries, lending to midsize companies is a highly profitable business and this will continue to be a core role of banks. As to whether to pursue universal banking or traditional banking, I believe the choice should not be made simply based on the size of a bank

Japan apparently has excessive assets, having an overcapacity of 20 to 40 percent. Return on equity of France, which is said to have low capital efficiency, is roughly three times that of Japan. I also agree that further realignment of the Japanese banking sector is necessary. I would like to count on the further development to generate microeconomic effects, which we have yet to see from the consolidations hitherto carried out.

Hoshi: As to the effects of consolidations, it is generally said that it takes three to five years to generate any effects. In this regard, I think a chance is still there. Concerning the situation regional banks, some of them are having difficulty in investing collected money through traditional ways. Decisions as to whether they should pursue universal banking or concentrate on traditional banking to cope with expected falls in deposits should be made by comparing profitability of each scenarios.

Q: I agree with your view that we are returning to a market-oriented system as seen in the prewar period. Concerning corporate governance, my impression is that Japanese corporate governance is diverse and different among shareholders but gradually converging into relational governance by institutional investors. In the light of future roles of the financial system, what kind of corporate governance do you expect to see in the future?

Not all the shareholders are small shareholders. We do have the so-called block shareholders and I believe such shareholders, in their relations with corporate managers, will play a big role in corporate governance.

Aoki (CRO of RIETI): Assets are being diversified. Banks, while being financial intermediaries themselves, should be able to play an intermediary role for other financial intermediaries. Today, people talk about initial public offering, and a successful buyout by Cisco Systems Inc. has been arranged by a venture capital. So, venture capitals also have roles to play. Japan's problem is that banks have been the sole financial intermediaries and there have been no entities specialized in respective services. So, I don't think that things are as simple as that the removal of regulations will change situations for better. There are shares held by "zaibatsu" corporate group members and there are shares which are not on the market. There are also institutional difficulties, too. Corporate governance in the prewar period was not sophisticated and failed to properly function at the time of the Great Depression.

The evolution of the U.S. markets has made greater progress lately. Banks' problem in the 1980s is more fundamental, stemming from Japan's corporate structures and labor market that have been in place for 50 years.

Hoshi: I should have explained more comprehensively, including the problem of employment system. I gave more detailed explanation in this regard in my book. As to the problem of zaibatsu shareholders, there are indeed a number of cases in which zaibatsu shareholders put member firms, including non-public companies, under control.

Q: What kind of systems are you referring to when you say market-oriented?

Stock-oriented markets, which I expect to emerge in the future, are different from those in the prewar period. In the prewar period, zaibatsu corporate groups and a small number of rich people provided fund to companies as shareholders, rather than ordinary people buying stocks thereby channeling money to companies. The markets I expect to see in the future is a U.S.-style market in which we, ordinary people, can participate.

Q: Regulatory reform proposals tend to be diluted by bureaucrats and politicians and it is difficult to carry out reform by mapping out institutional designs. I am concerned about distortion resulting from this. I am afraid that inflow of bank deposits will continue while major companies shift further away from banks. What is your view on the planned shift from the government's full protection of bank deposits to the "payoff" limited protection system?

Slower deregulation cause greater negative impacts and distorted deregulation is no good. It is necessary to carry it out all at once. As to the payoff system, Japan's bank deposits have been consistently on a high level since ever the postwar period, but explicit protection of bank deposits was implemented only in 1971. So, I think the fact that banks were kept under the protection of the Finance Ministry is not directly related to the high-level bank deposits in Japan.

Q: Don't you expect falls in bank deposits as a result of the shift to the payoff system?

Kawamoto: Only 0.4 percent of Japanese people has bank deposits worth ¥10 million or more. Although average bank deposit per household is ¥14 million, they can easily transfer exceeding portion of deposits to other family members. So, I don't expect any substantial fall in overall bank deposits. I believe banks destined to fail should fail quickly.

Q: What impacts do you expect on the industrial structure? What is your observation concerning relations between the development of information and telecommunication industry and a shift toward market-oriented financial system?

I have taken the industrial structure as a given factor. In the U.S., too, the extent of dependency on bank loans differs from one industrial sector to another. It is an important point to see how banks' role changes in accordance with the changes in industrial structures.

Q: Pension and other public systems underwent changes in the wartime. But systems in their nature are hard to change. A great part of the Japanese pension system is covered by the public pension system. So, without increasing the role of private pension systems, changes in the financial sector alone cannot create a new flow of money.

Hoshi: That's a very important point. When we look at overall economy, we find a number of mutually supplementary systems. But then, if one system begins to change, it may lead to changes in other systems. So, I think the financial sector can be a driving force of bringing changes to other parts of the Japanese economy. Both the employment system and public financing system will change, but there will be some variations as to how they will change.

Q: I am aware of changes taking place in the labor market. Of the so-called 1955 system, we should change the labor market and the financial market. Nippon Telegraph & Telephone Corp. has been split up and the wages of NTT's local employees have been cut by 30 percent. This is same as what the U.S. carried out in the mid-1980s. Currently, leading companies such as Matsushita Electric Industrial Co. is getting more applications than planned when they call for voluntary retirement. This is an indication of changes in the labor market.

Q: As to bank mergers and consolidations, both Mr. Hoshi and Ms. Kawamoto are hopeful of positive impacts of such realignment. But it is often pointed out that in Japan alliances and mergers hardly lead to changes in business and management styles. Foreign companies tend to replace the whole management team from the top to middle-class managers. What do you think of the reality that mergers cannot change business operations? Another question is about relations with other factors of economy. In the postwar corporate governance, a main bank sent personnel to a troubled company to reconstruct its business. Why did this system work well? How should we understand economic environment? And how should wee see the role of banks as a major shareholder?

Hoshi: As to the effect of bank mergers and consolidations, I see a chance but I am not expectant. Judging from the consolidations that have already taken place, I cannot be expectant. We will have to wait another three to five years but so far I see little evidence of improved efficiency.

Aoki: I find the replacement of the whole top management of the Mizuho Financial Group rather epoch-making.

Q: In case of Japanese banks, I am afraid that simply changing the top management will make little difference because those in the second in line will be in their place.

There was a time when governance by main banks worked well. At that time, those sent by main banks picked up right persons in the middle class and let them manage, rather than trying to manage on their own. Difference in economic environment is surely a factor (behind why the same system fails to work now). The main bank system worked well at a time when Japan was trying to catch up industrial countries and did not have to explore new strategies. Today, however, situation is different. We have to take risks and think what kinds of governance will fit for Japan.

Kawamoto: Mergers and consolidations between foreign banks are not always successful. Roughly 50 percent of cases are unsuccessful.

Q: Will stock investment become part of ordinary household investment activities?

Stock investment by ordinary households is different from risk money. I expect household financial activities will eventually shift to the one in which people buy trust funds. When we see a long-term revival of stock markets, it will change the allocation of financial assets.

Q: I don't think buying trust funds is a familiar idea for a Japanese household.

I think it is simply that they have not purchased in the past.

Q: How soon do you expect such changes will take place?

I expect we will begin to see significant changes in seven to eight years. I hope such changes will run their course in 10 years. But to make it happen, we must quickly proceed on the disposal of bad loans.

Q: Will direct financing function well? The question is whether Japanese banks can provide necessary fund for midsize companies. They have lent money only when such borrowers have collaterals. Once Japanese banks are done with the disposal of bad loans, will they be able to properly assess the credibility of their potential borrowers?

It depends on each bank. As a source of revenues, lending to midsize companies is very important. Capability of examining and scrutinizing viable midsize corporate borrowers is key to succeed and banks without such ability will fail. I believe there are some banks capable of this.