The Dilemma Facing Financial Policy: The Merits and Demerits of Signaling

With the sharp drop in stock prices since September thathas brought the bellwether Nikkei average to record post-bubblelows, concerns are once again mounting over non-performingloans and the stability of the banking sector. Although theseriousness of the issue over the past few years has not abated- if anything, growing in magnitude - it has more or lessbeen forgotten during times of relatively stable stock prices,as if the problem had been solved. For whatever reason, theissue of financial stability raises its head whenever stockprices fall or when companies close their books. This is similarto a situation where people standing in a pool (banks) arefine when the water level only comes up to their necks, butbegin shouting for help if the water rises any further. Suchscenes may appear comical from the sidelines. But for theparties 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 policywith an air of desperation about it. Furthermore, in the Cabinetreshuffle at the end of September, the reins of financialpolicy were handed from Hakuo Yanagisawa, who was said tobe reluctant to inject public funds into banks, to Heizo Takenaka,who is believed to see such a move as a viable option. Thesedevelopments point to a possible about-face in financial policy.Whether regulators use or abuse what is most likely theirlast opportunity to settle the bad loan issue once and forall hinges on their willingness to review the dilemmas facedby past financial administrations, and their mistakes. Inthis column, I would like to examine this issue from the viewpointof the effects of "policy signaling."

The Bank of Japan's announcement that it would buy sharesheld by banks was met by surprise from market players. Somewithin the government and the ruling coalition sharply criticizedthe move, as did some foreign media. The announcement certainlyleft us with the impression that the central bank had madea hurried about-face, since the BOJ up to that time had adamantlyrejected calls to boost liquidity and ease monetary policyby purchasing relatively high-risk assets. The BOJ had arguedthat this was impossible, as there was no way to make up forany capital loss incurred from such assets, and that doingso would greatly undermine confidence in the yen. For itspart, the BOJ likely believes that while concerns over thecapital loss issue remain, this new policy does not necessarilyconflict with its past stance, because it is an unusual, one-time-onlystep that does not seek to promote greater liquidity or shoreup stock prices, but solely encourages banks to shed theirshareholdings and reduce their exposure to stock price fluctuationrisks, which can greatly destabilize their management. Moderationand discipline are clearly important for both financial policyor fiscal policy. However, this does not support institutingtaboos in economic policy. In the event of drastic changesin economic circumstances, there will naturally be a needto implement bold policies, while remaining fully aware ofthe potential disadvantages of such policies. In other words,the appropriateness and desirability of a certain policy dependson specific economic conditions. Whatever the objective ofthe move, the central bank's purchase of bank assets shouldbe considered as part of a continuous chain of events broughtabout by changes in economic conditions. Oddly enough, itmay be said that on this occasion the BOJ itself proved thatthis holds true.

As for the purchase of bank shareholdings, details of thescheme were released on Oct. 11. While it premature to assessthis policy, I would like to point out two major implications.First, using policy measures to reduce bank shareholdingsmay be the start of a major turnaround in the financial systemitself, as we saw in the United States after the Great Depression,when the Glass-Steagall Act was established to prohibit commercialbanks from holding shares, after scandals involving certainbanks (among them JP Morgan) that had exerted strong influenceover companies as shareholders. A decline in bank shareholdingssignifies the end of the so-called "main bank model," in whichcorporate governance is enhanced and made more effective byhaving the bank serve as both a creditor and a shareholder.

Even more important than the policy itself is the signalit gives. The BOJ, which conducts its own inspections of banksindependently from probes carried out by the Financial ServicesAgency, is in a position to have full awareness of how banksare faring. However, if the central bank were simply to disclosethe wretched state of these financial institutions, a financialcrisis might ensue. Instead, for the BOJ, which is privy tothe internal situation of banks, deciding to implement a policyregarded as financial anathema despite a full awareness ofthe attendant risks and potential criticism, the new policyplayed a key role in sending a credible signal to the generalpublic that the deterioration of the banking sector's capitalbases and the instability stemming from this situation hadreached crisis levels. In fact, we can see the BOJ's strongresolve regarding non-performing loans in its paper on theissue released Oct. 11. In this document, the central bank- which had long refrained from tackling the bad loan problemhead-on despite recognizing its importance due to concernsabout meddling in matters beyond its jurisdiction - outlinesits willingness to act as the lender of last resort in timesof crisis, and at the same time urges (the government) toconsider injecting public funds into banks as a policy option.

Discussions of the credibility of such economic policiesare also seen in the arena called the "political economy ofreform.'' (Sturzenegger and Tommasi (1998)) According to thisargument, putting forward reforms that run counter to a policymaker'sposition increases the credibility of his or her policies.One example is the case in which a populist government suggeststhe implementation of market-oriented reforms. Even thoughsuch a move may erode that government's political base anddraw fire from ruling party lawmakers, it also underscoresthe painful necessity of such reforms and the critical stateof the economy, thereby increasing the credibility of theproposed reforms. (For example, John Williamson and othersat the Institute for International Economics in Washingtonconducted a case study which showed that of 13 countries thatimplemented market-oriented reforms, only three had rightistgovernments. The rest were leftist. (Williamson (1994))

On the other hand, with the removal of a financial servicesminister who denied the precarious condition of the bankingsystem, the government, through a strategic project team onfinancial affairs headed by Minister Takenaka, is also poisedto draw up an action plan. According to media reports, Takenakahas stressed the importance of three principles: (1) stricterasset assessment; (2) improved capital bases; and (3) bettergovernance when utilizing public funds to accelerate the processof bad loan disposal. As mentioned by the BOJ in its paperon the non-performing loan issue, there is probably no roomfor argument regarding the importance of more rigorous evaluationsof loans and examination of the procedures by which loan-lossreserves are established to better reflect reality. However,unless we reconsider why such moves were never fully implementedin the past despite recognition of their importance, we arelikely simply to repeat these mistakes.

The essence of the problem is that financial administrationin Japan is based on the premise that banks should not beallowed to fail. Such a tacit understanding clearly leadsto lax assessments by both financial authorities and the banksthemselves with respect to problem loans. Such a premise alsoleads to loan-loss reserves based primarily on the inclinationsof a particular bank.

Why not permit banks to fail? This is not unrelated to thesomewhat unique situation in Japan. Under a bad loan disposalframework based on normal bank supervision and banking theory,banks whose capital are at such low levels as to merit liquidationaccount for only a small portion of the entire financial system.However, in Japan, the collapse of the asset-inflated bubbleeconomy dealt a serious blow to practically all financialinstitutions. As regulators grappled with the problem of therebeing "too many (banks) to fail,'' (the large numbers of bankssusceptible to failure,) the situation continued to deteriorateas industry restructuring led to the creation of four majorbanking groups, thereby rendering banks "too big to fail.''There is no doubt that the government and ruling coalitionparties fear that a great many banks in Japan will becomecapital-short if active bad loan disposal is pursued. Dueto the associated scale, the possibility of financial crisisor systemic risk is much greater than in other countries,where bad loan problems have already been settled. No politicianwants to be remembered as the individual who triggered a globaldepression. But at the same time, we also need to reconsiderwhether the failure of a bank with negative net worth wouldreally lead to massive financial panic and systemic risk.Even if financial and settlements systems, which are partof a global network, are held hostage by the banking industry,authorities should demonstrate their determination to encouragebanks of negative net worth to fold their tents and make agraceful exit.

I say this because only when regulators can determine whichfinancial institutions are to fail can we seriously discussthe issue of whether to inject public funds into banks. Publicfunds should only be used to recapitalize banks that are fundamentallyviable, despite being capital-short at the present, not banksthat have already fallen into the territory of negative networth. However, such a capital injection poses two dilemmas.The first is the issue of the responsibility of bank managementand financial regulators. If public funds are injected intobanks, financial authorities and top management at those bankswill be called upon to shoulder some form of responsibility.But because neither party wishes to do so, more often thannot, they will simply maintain that "public funds are unnecessary.''In other words, this is a dilemma in which the banks thatmost need public funds reject capitalization offers. Someform of mechanism must be established that transcends boththe industry and regulators and can forcibly infuse publicmoney into banks.

The other dilemma is that the public fund injection itselfmay serve as a signal. To receive public funds, a bank mustpresent details of its capital base after rigorously assessingits loans and making the appropriate allowances, or sellingoff loans at loss-incurring prices. This means that the amountof public funds needed for recapitalization will vary frombank to bank. But the market may turn on a bank (a suddendrop in stock price, confusion in the interbank market), ordepositors might make a run on a bank if the contents of itsbalance sheets differ from market perceptions. Even if suchinformation were not disclosed and only the amount of publicfunds injected made public, so long as those figures accuratelyreflect actual capital levels, they effectively become signalsthat reflect bank balance sheets. Thus, when the figures forpublic funds injected into individual banks are revealed,the same potential remains for same confusion among marketsand depositors. Under these conditions, the appropriate policyfor the situation may send a signal that triggers a financialcrisis. Banks received injections of public funds on two previousoccasions: In March 1998, all major banks received 100 billionyen. The infusion amounts varied more in March 1999, but whenthe figures are recalculated based on the scale of bank assets,there was very little difference in the amount received byeach of the major banks, except that the former Fuji and Daiwabanks received a little more than the others, while the formerSumitomo Bank received slightly less. Excessive concern forthe potential effects of injecting appropriate amounts ofpublic funds inevitably results in even-handed distributionof funds in amounts too small to have significant effect.However, if authorities continue to make these small, uniformcapital injections, it will only serve to magnify the magnitudeof the resulting signal once they actually determine to injectpublic funds in amounts that reflect the realities facingthe banks.

Now is the time to seriously discuss how these two dilemmascan be overcome. Banks that ought to fail should be permittedto do so. If the harmful repercussions of their collapse threatensthe operations of healthy banks, the BOJ should interveneas the "lender of last resort.'' In addition, to minimizethe effects of signaling, the comprehensive disposal of non-performingloans should be carried out in tandem with public fund injections,and this must be a compulsory, one-time-only act. This representsa major procedure on which the very life of Japan's financialsystem may depend.

* This piece first appeared as the RIETI Column No.41 onOctober 17, 2002.

October 17, 2002

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