"The Japanese Consumer Finance Industry: A study in re-regulation"

Before the current financial crisis, global governments and businesses focused on deregulation. Not all players wanted to deregulate, but since the 1980s deregulation was generally seen as positive for the financial industry. The financial industry saw deregulation as an opportunity to achieve higher profits. Deregulation was also seen as positive to customers and users of the financial industry as various products were meant to contain risk. Such feelings were also prevalent in Japan in several industries.

In the wake of the financial crisis, countries are scrambling to re-regulate. Deregulation is now not seen as an absolute positive. U.S. credit card legislation curtailed raising rates without notice. Stress testing and capital requirements are being imposed upon banks, and there are now tighter controls on derivatives.

Well before the financial crisis, Japan has been re-regulating the consumer finance industry. Money lending was essentially a completely deregulated industry after the war. There was no real enforced maximum lending rate (although one existed in principle), few barriers to entry, and as a result, externalities like loan sharking, usury and criminal activities were rampant. Since the immediate postwar period, the government has steadily re-regulated. Maximum lending rates were reduced, and money lenders were required to register with authorities and meet capital and asset requirements. Illegal lenders were also persecuted.

There have been two periods in which there was a flurry activity to change consumer finance legislation, including the Sarakin scandals of the 1970s and the events of 2006. 2006 was not a bad time for the economy, especially compared to now. Total consumer credit volume at the time was 75.5 trillion yen of which sales on credit was 45 trillion yen. Within total consumer credit, consumer finance was 30.5 trillion yen, of which 8.7 trillion yen were secured loans. Consumer loans were 21.9 trillion yen within consumer finance, of which moneylenders accounted for 9.3 trillion yen and the remaining amount was other lending. Credit card cashing rates were not that different from consumer finance rates.

In order to explain what happened, the past structure governing consumer finance in Japan must be discussed. Until the recent revision, the Interest Rate Restriction law set the maximum lending rate, and there were no criminal penalties on non-compliance. These laws applied primarily to banks. There were also money lending laws like the Capital Subscription Law which set the maximum lending rate at 29.2%. The Money Lending Business Control Law required registration of lenders. Violation of these rules could result in jail time or fines. The gap between the rates set in these laws is the "grey zone" which is neither completely legal nor completely illegal. This situation has existed since the end of the war, but the grey zone has decreased in size since that time.

In 1983, maximum lending rates began to fall again. There was a long period at which maximum lending rates were around 40%, and the maximum rate has now come down to around 20%. Rates are to be unified and will come down to between 15-20%. Japan had been steadily regulating, with talk of how over-borrowing and the proliferation of consumer finance companies was a negative development. The government has aimed to deal with these problems, though the way it has come about has not been a smooth and controlled process, seeming ad hoc at times.

The Supreme Court made a ruling in 2006 to make it easier for individuals to collect repayment of interest in excess of that allowed under the Interest Rate Restriction Law (grey zone interest). The court ruling called into question the legality of the grey zone. This prompted revisiting of the rules governing money lending and forced companies to create grey zone reserves. People were entitled to claim the "extra" interest they paid from their lenders.

Revisions to the money lending laws were passed, and by June 2010, the maximum lending rate will be unified to rates specified under the Interest Rate Restriction Law, thereby eliminating the grey zone. Loans will be limited to a third of borrowers' annual income. For loans exceeding 1 million yen, moneylenders would be obligated to inquire about the applicant's annual income. Implementation is still ambiguous. Regulators are to have more power, such as the ability to issue business improvement orders.

The rate decline held various consequences for the industry. Margins were lowered as lenders were forced to lower their lending rates. There was a reduction in volume, with loans to current borrowers no longer being profitable, some customers were deemed too high-risk to borrow at the lower rates. Customers could borrow less due to new legislation restricting total loans as a percentage of income. Also, there has been a rise in write-offs.

The result of all of this is that the number of registered money lenders has dropped precipitously since regulation began in 1984. The loan market is an oligopoly with 60% of the total loan balance with the Big Four, and 90% percent with the top 25 firms. This oligopoly was created in reaction to regulation.

Stock prices for money lending companies began to drop steadily in 2006, predating the current economic crisis. The necessity for grey zone reserves has caused problems in money lenders' balance sheets. In March 2007, there are many large negative numbers visible in the balance sheets of Aiful, Takefuji, Acom and Promise. Loans approval rates crashed around 2006, with Aiful only accepting 7% of loans recently, down from over 50% before the 2006 Supreme Court rulings. Every month, 25-30 billion yen is paid out by money lenders to customers in grey zone claims, increasing steadily since 2006. Grey zone refunds have begun to pick up recently as a result of the recent economic crisis.

The consequences of the court ruling and the re-regulation are that the Big Four companies found direct funding difficult. Credit default swaps have increased dramatically for Takefuji and Aiful, who are now essentially priced to fail. Bond yields also increased and going to market is difficult for these companies.

From the regulator's perspective, re-regulation has been largely a success, given their aims. The size of the industry and the number of players have been reduced. The government has greater control on the industry and over-borrowing has been reduced. In regard to this last goal, its success is unclear as black market statistics are not reliable. In fact, anecdotes suggest that black market lending demand has increased.

Not surprisingly, re-regulation has been disruptive to the industry. Oligopolies have been created as the Big Four most legal money lending. Acom and Promise have been pushed into relationships with mega-banks, while Aiful and Takefuji default swaps were priced to fail. The profitability of the industry has been demolished, with huge losses and a crash in market control amongst the Big Four, and a fall in loan volume of 25-30% with more to follow. Also, there is reduced consumer access to legal credit. Questions remain as to whether the over-borrowing issue has been solved and whether black lending has increased.

Q: Around 1977, Sanwa Bank had several restrictions on home loans which made it near impossible for average Japanese people to gain financing to buy a house. How is this situation tolerated currently?

Yuki Allyson HONJO
That is exactly the story that is being told; people that do not need the money can get a loan. People are struggling even as Japan calls itself a middle-class nation. In reality, there are many who are not middle class. Such cash-flow financing came about due to this, and the secrecy of the system. It will continue to be difficult for those of a certain income in the middle class to get housing loans. I am not certain whether this legislation actually helps the consumer or not.

I do not know why the system is tolerated by the Japanese people. This regulation was put in place because of a court decision, though the decision was likely due to activist judges. A number of individuals had a huge amount of power to impact change, but it is hard to pinpoint how things change.

Q: Regarding the grey zone reserves, do money lenders have to cover 100% of the potential payout from the legislation. If not, what is the percentage of the total payout that they must keep in reserve?

Yuki Allyson HONJO
The calculation is set based on current trends. It is interesting that regulations say that this number should be "adjusted as necessary." The problem is that this is a backward looking calculation. Looking forward, if the economy gets worse, more people will be asking for grey zone money back, thus necessitating increases in reserves. This is not based on a theoretical amount, since that number is huge and almost impossible to calculate.

Q: If the reserves were big enough, it may be better to dissolve the company and hope that less than 100% of borrowers would ask for their money back.

Yuki Allyson HONJO
What is interesting is that these companies had huge equity to asset levels. Many consumer finance companies in the world have equity to asset ratios of 7-20%. Takefuji had nearly 50%. That came down because they had to put huge amounts of money into reserves. If the company is dissolved, the law still says that the money has to be paid back for a given amount of time.

Q: The decision making process in Japan versus the U.S. has politicians and bureaucrats being wary of giving strategic numerical targets for ongoing restructuring. If they do give a numerical target for effects that are to take place, the media will latch onto it and not let it go. This was the case in the energy markets. Regarding the consolidation of the industry, was this just a windfall, or was it apart of a plan to bring down the number of lenders. Have politicians originally talked about doing this or is it just an accident brought about by a court decision?

Yuki Allyson HONJO
The original plan appears to have been to decrease the number or firms. In 1980, there were 220,000 firms and the FSA was having difficulty regulating. When the maximum lending rate was brought down and registration was required, the number of companies was brought down and greater control was acquired, thus fulfilling an aim of the government. There is little to suggest that there was a number the government had in mind, but a smaller market with greater government control was vaguely understood to be a goal. The 2006 court ruling sped up the schedule of regulation, but LDP politicians, may not have intended for a 10% drop in lending rates right away. They may have envisioned a more incremental, slower process, and they may not have intend for the Big Four to be hurt as much as the court decisions did.

Q: Do you think that the post-2006 situation was inevitable, regardless of the court decision, or was it an historical accident?

Yuki Allyson HONJO
Eventually, this situation would have played out. The original structure of the laws was an untenable situation for a mature economy. If banks wanted to get into consumer finance, the maximum lending rate should have been increased. That discussion got blown out of the water because of the courts.

Q: Microcredit allows high interests in certain models, which may not fit Japan's situation, but is it necessary for certain societies to have high interest rates for certain business models?

Yuki Allyson HONJO
My personal view is that every economy needs to have some ability for marginal borrowers to be able to borrow. People need to understand what they are doing, nor should they be forced to deal with unduly harsh consequences if they fail to pay, but there should be some consideration for marginal borrowing in every economy. This is now gone in Japan. The average size of the loans from these companies was around $5,000, making it, essentially, a for-profit, less high minded, Grameen Bank. There is an issue of abuse, and as long as that issue is not there, this facility should exist.

What is interesting about Japanese consumer finance is that it is about need. Going back 20 years, money was not available from ATMs at night. These companies met a need and had a nation-wide network and opening hours till 22:00, both of which banks did not have at that time. Banks, in those days, were not interested in pricing a $1,000 or overdraft loan to anyone, nor were they interested in processing these loans or staying open late. While the reputations of these companies were bad, they met a need and built the technology and network which banks did not.

Another quirk about the consumer finance industry is that around 20 years ago, one of the big aspects of consumer finance was lower and middle income men getting allowances from their wives. In such households, the wives would control the finances and give the husbands allowances. The average allowance before the bubble was around 30,000 yen. This caused men to borrow money from money lenders rather than asking for more money from their wives. Secrecy was key factor for the industry for this reason. As household dynamics have changed, this is not as much of an issue as it once was.

Q: Consumer education is important in keeping people from going bankrupt. Spending money can be a stimulant for the economy, but saving money is important for the future and balancing an individual's budget. For example, if one saves, they will always become a richer person and never go bankrupt. The element of the education method is important from the viewpoint of protecting the consumer. Regulation is very important, for example as a way to minimize the borrowing level. What element of consumer education is important in this regard?

Yuki Allyson HONJO
In some ways, governments try to avoid this. By enforcing a limit to borrowing based on one's income, there is no need to educate people. Also, it is very difficult, but being numerate and understanding what you are signing is important. The Big Four are required to explain the contract clearly, which is helpful. Also, high school education explaining how credit cards work is also useful. There is not much consumer education in the U.S. in this regard.

Q: The Ministry of Education offers some guidance in teaching high school students. Consumer education is a very important element for high school students' curricula. From the viewpoint of national policy, consumer education is important, but detail and content is very difficult.

In consumer education, students are taught to be careful when buying and how to check balances and budgets. On the second level, they learn details of the law. At a more detailed level, students tend to become confused.

Yuki Allyson HONJO
Calculations like finding out how much grey zone money you will get back requires a spreadsheet, including what exact payments were made and when they were made. It may not be valuable to know that, but it is probably valuable know that one must pay back their credit card bills on time. I don't think it is part of the required cirricula in the U.S. The U.S. falls flat in that regard.

Q: What is your personal assessment of the second Supreme Court ruling? My personal view is that the second Supreme Court ruling might hurt the background of the consumer finance industry because after the Supreme Court ruling, there is no rational ground with which the companies can calculate the necessary reserve amount that money lenders need to hold. The activities of the consumer finance companies were unjustifiable, but the second Supreme Court ruling may damage the basis of consumer finance as an industry.

Yuki Allyson HONJO
Regarding the first Supreme Court ruling, the idea of retroactively deeming a contracted rate as invalid and necessitating a return of that money is somewhat strange. However, if the first ruling is accepted, the second ruling makes some sense. The ruling says that a line of credit is a single and continuous credit event. This means that if a credit line is opened, when money is paid in or taken out, those are not single events. The legal argument says that this string of events is a single evenyt, and the start of that event was the first transaction. That makes sense in light of the first Supreme Court ruling.

Q: For some reason, Japanese courts have generally not been very activist, but they have been activists before Word War II. Before the war judges were active in housing rental laws, while after the war they were active in crackdowns on loan sharks. The ultimate outcome of all this is that Japan has some of the strictest restrictions on interest in consumer lending outside of the Islamic world.

Yuki Allyson HONJO
I wonder what happens if and when cost of funding normalizes, as it is very cheap at the moment. What happens if, within 20 years, 10 year money becomes "normal"-- say 5-6%?

Q: Presumably, even though the volume of this consumer lending has gone down substantially, Japanese consumption has not come down proportionately. There is only so much cash, so some people may actually not be borrowing anymore, but there are others who have to keep spending or feel the need to keep spending, and these people must be going somewhere.

Regarding the thousands of consumer lending businesses which managed to survive, what kind of business models do they have? They are not following the letter of the law in the way that the Big Four are, so looking at these businesses and extrapolating from there, you can guess where people go when they go down the credit rating scale.

Yuki Allyson HONJO
Certainly, some of these smaller companies have extremely questionable practices. In 2006, the media went wild with stories of people driven to suicide due to abusive, but legal lenders. Bad things happen on the margins in consumer finance. Promise, Acom and Aiful are required to behave because they are listed companies, as is Takefuji, even with its colorful history. Once legal lenders cannot meet exam standards and asset value standards, they may simply continue to run, but run illegally and charge a higher margin to cover the risk.

Q: Are more consumers opting for credit card use? If that is the case, what effect will this have on Japan's GDP? There has been much talk about the GDP formula and the consumer spending element to it. This discussion has focused on deregulating to allow consumers to spend more and thus allow GDP increases without the other structural measures that the government had been implementing. The question is whether consumer spending has actually increased and whether these kinds of measures actually do anything to spur economic growth.

Yuki Allyson HONJO
This re-regulation is actually the opposite of deregulation. Regarding trends, credit card use has increased as more standard, regular charges like water, gas and Suica bills are being charged to credit cards. These are extremely low margin payments with low merchant fees, but it has increased the usage per month. Certainly, credit card companies went out of their way to get people to use their credit cards more frequently, and some have been quite successful by offering certain incentives. Increasing the places in which credit cards can be used has helped. Re-regulation impacts credit card cashing, rather than credit card shopping.