It now seems certain that major Japanese banks will achieve their goal of halving the ratio of nonperforming loans (NPLs) to total outstanding loans by the target date. Meanwhile, measures taken under the Program for Financial Revival are set to expire at the end of March 2005. Against this backdrop, the government is to formulate another set of measures, tentatively called the "Program for Concentrated Consolidation of the Financial System," for implementation in the next fiscal year starting April 2005. Since it was set up in late October, an advisory team for Financial Services Minister Tatsuya Ito has been discussing various schemes. Based on the recommendations put forward by the team, the Financial Services Agency will begin formulating the program toward the end of this month. The general direction of the program has been already set forth in the government's "Basic Policies for Economic and Fiscal Management and Structural Reform 2004," which calls for a shift from financial regulations that emphasize measures to tackle NPLs, to regulations focusing on the following five pillars: 1) building a solid and vigorous financial system; 2) enhancing management through voluntary sustainable efforts by individual financial institutions; 3) promoting local and small business financing that can contribute to the revitalization of local economies and small businesses; 4) providing a variety of highly sophisticated financial services that can meet various consumer needs; and 5) establishing transaction rules based on actual financial conditions, thereby assuring users of the soundness of the financial system. In this article, I will discuss several points that should be kept in mind in formulating the Program for Concentrated Consolidation of the Financial System, in order to create an overall framework for financial administration from fiscal 2005 onward.
The NPL problem is not over yet
As a starting point for drawing up the new program, it must be recognized that even if major banks halve of the ratio of NPLs to total loans, this alone will not resolve Japan's NPL problem. Local financial institutions generally lag behind major financial institutions in disposing of NPLs. Obviously neither enhancement of the relationship banking system nor realignment of local financial institutions will solve the problem of NPLs held by local financial institutions. Financial regulators have been promoting mergers and consolidations among local financial institutions as a means to stabilize the financial system. Such realignment, however, has not happened as quickly as hoped because very few local financial institutions, if any, dare to initiate merger or consolidation talks. It is widely perceived that such a move is tantamount to asking for help from another financial institution. The top executives in such institutions fear they will loose their jobs in any combined entity should they initiate merger talks. They are also reluctant to apply for injections of public funds under the financial function reinforcement law because they are afraid of government intervention.
Thus, local financial institutions generally have little sense of urgency about the need to reconstruct their managements. This is a natural consequence of the financial regulation system instituted by former Financial Services Minister Heizo Takenaka, which drew a clear line between major banks and local ones - applying sticks to the former and carrots to the latter.
Indeed, the rhetoric in which the NPL problem is presented as affecting only a limited number of major banks has been effective at winning public acceptance of the process, and in terms of government policy implementation. At the same time, this rhetoric has diverted public attention from the problem of local financial institutions. This dichotomous approach to policy implementation vis-a-vis major banks and local financial institutions seems to explain the "paradox of the Takenaka financial administration," that is, why there has been only one bankruptcy among financial institutions (Ashikaga Bank) in fiscal 2002 and 2003 after the Program for Financial Revival, a scheme touted as a "hard landing" strategy, was put in place, whereas the preceding several years witnessed multiple failures among financial institutions..
Japan's financial regulatory system, which is premised on continuing assistance to local financial institutions to cope with the NPL problem, has reached a turning point. The government needs to switch from a "crisis mode," in which financial system stabilization is of the utmost importance, to a "normal mode." There are two important points that must be kept in mind in making a successful transition in the financial administration system, which I explain below.
Financial administration must not become an ill-advised "industrial policy"
The government's interventions in banks' management made under the crisis-mode financial administration must not continue, through inertia, under the normal-mode. Forceful government management, intervention and discipline are critical in times of crisis, as indicated by the fact that the Program for Financial Revival calls for such intervention as one of the program's three pillars. In Japan, such strong-arm tactics take the form of strict application of the so-called 30% rule, whereby regulators issue a "business improvement administrative order" to any bank underperforming its stated profit target by 30% or more, which leads to remarkable improvements in banks' governance. But such government-administered governance standards should be limited to times of crisis. Should crisis-mode behavior persist on the part of financial institutions and regulators, financial institutions will become dependent on government instructions for every step they take; rather than cutting red tape, they will avoid the risk of punishment by waiting for guidance. The financial regulators, for their part, may be tempted to return the old-fashioned system of discretionary administration. It is also possible that inspections and supervision implemented by the government may, in a single misstep, become a tax-financed "health checkup" or "management consulting" for banks. Government intervention under normal circumstances should be limited to discouraging excessive risk-taking by banks. If one or several major banks fail through such excessive risk-taking, this may set off a chain reaction among other banks and borrowers, resulting in major systemic problems. Such negative externalities resulting from bank failures, which are far greater than those caused by the failure of a non-financial company, are one of the major factors that justify government regulation and intervention in the industry.
I am concerned because I sense that the government's intent to "shift from administration focusing on the normalization of financial system to one designed to strengthen the international competitiveness of financial institutions" lies behind the pillars of the Program for Concentrated Consolidation of the Financial System. The Basic Policies for Economic and Fiscal Management and Structural Reform 2004 calls for "the world's highest level of financial function" in accordance with users' needs. This shows that the strengthening of the competitiveness is certainly intended, at least to some extent. Indeed, the aforementioned advisory team seems to have discussed the international competitiveness of financial institutions and their positioning as a strategically important industry. However, enhancement of competitiveness is a task individual financial institutions should undertake based on their own judgment and expertise. The government's job is to create a sound environment that facilitates competition, for instance, by focusing on measures to remove regulations that obstruct competition. The government should, by all means, prevent financial administration from turning into an ill-advised "industrial policy."
Sufficient discussion should be made on the convenience of users
Based on the above recognition, the most important task in implementing post-NPL policies is to give sufficient consideration to the convenience of (domestic) users. During the more than 10 years since the bursting of the economic bubble, various policy measures have been implemented to solve the NPL problem and restore stability to the financial system. This resulted in greater concentration in the financial industry through a series of bank failures, and a major realignment through mergers and consolidations. Now that major banks have been consolidated into four "mega banking" groups and local financial institutions, particularly shinkin banks and credit cooperatives, have been realigned and many of them weeded out, the total number of financial institutions in Japan has fallen substantially.
But it is about time to ask whether the convenience of users been impaired as a result of this consolidation. From the viewpoint of consumers, a decline in the number of financial institutions means fewer options in selecting a bank. Also, in the absence of rivals, banks may not focus sufficiently on the needs of consumers. Consolidation and closing of branches, while a major source of cost savings for banks, also leads to a loss of convenience for users. Although this is just my personal observation, it now seems to take longer to speak to a bank teller or to use an automated teller machine (ATM) following the mega bank mergers and consolidation. Merged or consolidated mega banks have also raised fees for various services. Thus, the primary impact of concentration could be harmful to consumers unless the benefits of mergers and consolidations, such as synergies and cost reductions, are properly passed on to consumers in the form of reduced fees or improved service.
An analysis of data on foreign banks shows that the effect of a bank merger on lending and deposit rates varies widely, from a modest impact on consumers to a substantially negative impact. However, findings from recent empirical studies also indicate: (1) consolidation lowers the deposit rate in the short run, although it brings efficiency gains to consumers in the long run (Note 1); (2) in-market or horizontal mergers, unlike out-of-market mergers, generate substantial market power and lower the deposit rate (Note 2); and (3) bank mergers tend to increase interest rates on consumer loans for which market is segmented, but to reduce rates on automobile loans where the market is large and where banks face competition from non-bank lenders (Note 3). That is, certain mergers tend to generate negative effect due to concentration, depending on the length of time that has passed since the merger, the characteristics of merger and the type of financial services offered. Seen in this light, ongoing mergers among local financial institutions, which are being promoted by the government, can be defined as in-market mergers within a segmented market. And this raises concern that such mergers may harm consumers. Meanwhile, in the case of mergers and consolidations among big banks, empirical findings show that positive effects begin to emerge about three years after the merger in the form of improved efficiency. Now that three years have passed since a series of mega bank mergers took place in Japan, it is important to examine to what extent this consolidation has generated efficiency gains.
At a time when the stabilization of the financial system was the single most important task for financial regulators, it was rational for the government to promote bank mergers and consolidations despite the possibility of adverse side-effects, such as moral hazard on the part of banks and depositors. But in shifting from crisis-mode to normal-mode financial administration, the government needs to squarely address the issue of the negative impact on consumers that may result from concentration. As the government formulates the Program for Concentrated Consolidation of the Financial System toward the end of this year, it is strongly hoped that there will be sufficient discussion of the negative aspects of bank mergers so as to incorporate policies in the program that will maximize consumer convenience.
* Originally published in Japanese on November 30, 2004
November 30, 2004
Note 1: Focarelli, D. and F. Panetta (2003), "Are Mergers Beneficial to Consumers? Evidence from the Market for Bank Deposits," American Economic Review 93(4), pp 1152-1172.
Note 2: The article cited above, and Prager, R. and T. Hannan (1998), "Do Substantial Horizontal Mergers Generate Significant Price Effects? Evidence from the Banking Industry," Journal of Industrial Economics 46(4), pp 433-452.
Note 3: Kahn, C., G. Pennecchi, and B. Sopranzetti (2000), "Bank Consolidation and Consumer Loan Interest Rates," mimeo.
