Reinvent Bank Culture and Business Models

Fellow, RIETI

Policy debate over the creation of a more effective mechanism to infuse taxpayer money into troubled banks is gathering pace. The envisioned new system would allow the government to carry out "pre-emptive" cash injections into banks before their capital to assets ratios fall below the acceptable levels of capital adequacy.

As the shocking episode of a taxpayer bailout of the Resona Group shows, Japan's banking system is beset by a deep-rooted disease. The question facing policy-makers and bank regulators is what is the most effective way to use public funds to restore health in the banking sector. I will propose five basic principles essential for effective cash injections based on the experience in the Resona rescue and the bitter lessons from previous bank bailouts with public money.

1. Use public funds to cut banks' losses

The government pumped taxpayer cash into undercapitalized big banks twice before, in 1998 and 1999. But the massive cash injections failed to make a big dent in the mountain of bad debts in the banking system or quicken the pace of bank reforms. The main reason for the poor results was the assumption among the government and the public that the public funds were in essence taxpayers' loans to the banks that should be repaid as quickly as possible.

If these banks write off a huge amount of nonperforming loans, their capital bases inevitably shrink significantly, forcing them to use the public funds they have received to replenish their capital. Then they find themselves unable to pay back the money supplied by the government. This grim prospect deterred them from embarking on a drastic cleanup of their books.

If the government is to avoid making the same mistake, it should first make clear that the public money used for saving troubled banks represents taxpayers' investment in the banks and may not return to them.

When a bank decides to continue supplying loans to a troubled borrower to keep it afloat, based on an optimistic evaluation of its ability to repay the debt, the bank runs the risk of ending up losing a larger amount of money. It would be wiser then for banks to evaluate their borrowers' financial conditions strictly and pull the plug on those with poor creditworthiness so that they can cut their losses early, using the public funds to cover the resultant dents in their capital bases. The eventual losses they sustain would be smaller - good news for taxpayers who are shareholders of these banks.

Banks that cannot be cured even with this radical remedy would only continue producing losses for taxpayers. Moreover, a prolonged period of virtual nationalization where banks are owned by the public could hinder banks from regaining management independence. So it is important to draw up a management plan for these banks that clearly defines their future fate in a specific time line: re-privatization or liquidation three years after the cash injection, for instance.

2. Give incentive for quick injections

Banks are reluctant to accept public funds because such a taxpayer bailout means their executives will be held accountable for the current trouble while the government meddles in their management. As they try to maintain the legally required capital ratios without public money, they must shrink their balance sheets by shutting off lines of new credit and calling in existing loans. These efforts by banks to shore up their capital bases effectively worsen the deflationary downturn and cause bad debts to grow further.

In order to be able to decide on cash infusions before it is too late, the government needs to have accurate and current information about the conditions of banks assets, or their loan portfolios. Auditors are responsible for examining and verifying banks' evaluations of their assets and classifications of their loans.

Given the heavy public responsibility born by audit firms, steps should be taken to prevent banks and auditors from developing cozy relations, such as putting a three-year time limit on an audit contract with the same firm.

It has been reported that banking regulators put pressure on the firms auditing Resona's books to do their job less rigorously so that the bank could avoid asking for a bailout. As a step to secure independence, neutrality and fairness of audits, the minister in charge of financial services should issue a special statement declaring the government has no responsibility whatsoever for bank audits.

3. Inject enough cash and improve the quality of capital

One big problem with Resona's capital was a large share of so-called deferred tax assets that can only be realized if the bank earns sufficient taxable income in the future. In injecting public funds into a bank, the government should try to increase the quality of the bank's capital as well as its ratio to assets to enhance public confidence in the bank's financial strength.

In concrete terms, the government should increase the bank's capital other than deferred tax assets while raising the ratio of Tier 1, or core capital to overall assets to the levels at major Western banks. That would also lower the stakes of existing shareholders substantially, cutting their influence over management.

4. Replace the banks' management and renew asset evaluation

When a bank receives a government injection of capital, its top executives should resign to take responsibility for the mess they have created and to make it easier for the bank management to make a break with the past. Issues like their retirement packages can be sorted out on a case-by-case basis. The new management team should consist mainly of young, talented employees within the bank and outsiders without any links to the bank's past.

The new management team should carry out rigorous evaluations of the bank's assets and divide the assets into two separate accounts: one for good assets and the other for problem loans and other bad assets. The new team must take full responsibility for the good assets, while clear rules need to be established on how the losses from the bad assets should be shared between the government and the bank.

5. The only management goal should be to maximize the banks' shareholder value

Since the rescued bank is now owned by the public as a result of the injection of public funds, the new management team has a duty to do its best to maximize the bank's value for the public. Besides drastically reducing the bank's bad debts, management needs to repudiate the old business model characterized by lending decisions based almost entirely on the value of collateral.

The consensus among bank analysts is that Japan's banking sector is overcrowded. Competition among too many banks operating in the same areas of business strips away profit margins on most products and services, sapping their staying power.

The new management's task is to build a new business model for the bank, like a one focused more on accurate credit analyses in lending, as part of the effort to improve its profitability.

Another important task is to slim down the operations and sell off unprofitable businesses. The effort for higher efficiency and profitability would also involve regrouping the bank into several parts pursuing different lines of business, such as the growing business of advising on mergers and acquisitions. The management could even opt to sell off all the bank's businesses. Many such moves would trigger a major shakeout in the banking sector and thereby contribute to rejuvenating the Japanese economy.

The government should not impose any goal or condition on the new management team other than maximization of the bank's shareholder value. In particular, any target for loans to small and medium-sized companies should be scrapped to make clear that banks are not expected to shoulder part of the burden of rescuing cash-strapped smaller businesses.

The public nature of the banking business lies only in banks' relations with their depositors, and their relations with corporate borrowers are purely business ties. The social goal of bailing out vulnerable small businesses should be achieved through the government's other policy measures.

Quick injections of sufficient public funds into undercapitalized banks-a new approach to taxpayer bailouts-would not re-energize Japan's banking system by itself, however. It is also vital to recruit more people with the capacity for new thinking to reinvent bank cultures and business models.

>> Original text in Japanese

* The article was reprinted from International Herald Tribune / The Asahi Shimbun on August 2-3, 2003. The original article appeared in The Asahi Shimbun on June 22, 2003. No reproduction or republication without written permission of the author and The Asahi Shimbun.

August 2-3, 2003 International Herald Tribune / The Asahi Shimbun

August 5, 2003

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