RIETI Policy Debate

Round 10: Assessment of Administrative Order Urging Capital-injected Banks to Improve Business Performance—Blind Spot of Policy Singling Out Profitability

TSURU Kotaro
Senior Fellow, RIETI

On July 28, the Financial Services Agency unveiled a set of three reports, each compiled by a relevant working group under the Financial System Council, on a mechanism for the infusion of public funds into financial institutions, capital adequacy requirements, and regulations on trust business. Then, on Aug. 1, the FSA issued an administrative order to 15 banks, urging them to improve their business practices. This administrative step came after the banks - all recipients of public funds - drastically failed to fulfill profit targets pledged in their respective "business revitalization plans," which were submitted to the government prior to the recapitalization. Specifically, the banks were ordered to submit a renewed business improvement plan by no later than Aug. 29, and report on the state of the implementation of the plan every three months thereafter. In this article, I would like to assess the above government measures given the current climate.

Now is about time that the FSA examined banks' financial statements for the past fiscal year and begun taking follow-up measures. But even taking this into account, the issue of the administrative order for business improvement may give an impression of abruptness, given its timing. Also, underneath this action can be seen intention by the FSA officials to minimize political friction by unveiling these controversial policies at a time when the regular session of the Diet has just ended and ruling party politicians are beginning to waver in anticipation of a possible snap election. As I will detail below, however, the FSA has in fact taken a series of cautious, yet also uncompromising strategic steps in preparation for the issuance of this order.

With regard to banks recapitalized with public funds, the FSA had earlier announced the so-called "30 percent rule" (see note), which laid down a sequence of administrative steps to be followed in the case of banks substantially underperforming in their respective "business revitalization plans." More specifically, it was stipulated that if a bank's return on equity (measured by the ratio of net business profit against equity capital) or its bottom line profit should miss the target by 30% or more, the FSA - after taking a series of designated steps - will instruct the bank to submit a new and more rigorous business improvement plan, and then consider issuing an administrative order to ensure the implementation of it. Meanwhile, the Program for Financial Revival, announced last year, says that where a bank has failed to achieve targets set in its business improvement plan, the FSA is to "take appropriate administrative measures, judging necessity on cause and extent of failure." If there is still no further improvement, the program states that the FSA shall, "take rigorous measures including clarifying the responsibility of the management." The wording of the program means to show the toughening of the FSA's stance on capital-injected banks. The FSA are rattling the saber, preparing to invoke the last resort measure, referred to as an administrative order for business improvement, as detailed under the terms of the 30 percent rule.

Furthermore, in April this year, the FSA put up an even tougher stance, stipulating that the FSA is to take rigorous actions "through business improvement administrative orders" against any bank falling 30% or more short of their commitment, after "strictly" scrutinizing the causes and extent of failure in evaluating the necessity of such an order. If the same bank, despite measures taken in line with the administrative order, misses the target by 30% or more again the following fiscal year, the FSA will urge the bank management to clarify their responsibility, specifically, in the form of the stepping down of chief executive officer and those serving in an equivalent capacity, as well as drastic cost cuts (compression of pay scale, reduction in the number of executive officers, etc) and so on. Should the bank fail for a third fiscal year, despite all these measures, the FSA would exercise its shareholder's right to convert preferred shares into common shares and thus virtually nationalize the bank. As such, the FSA has spelled out step-by-step procedures based on the 30 percent rule, gradually tightening its grip over bank governance.

It is therefore of utmost importance that the 15 banks - those subjected to the administrative order for business improvement - avoid red ink throughout the current fiscal year to the end of March 2004. Should they fail and suffer another loss-making year, it would also become difficult for them to include deferred tax assets as a component of capital and they might be forced to follow the same path as Resona Bank toward virtual nationalization. In this sense, these banks have no time to lose in improving profit performance.

According to media reports, these banks reacted to the administrative steps with resistance, branding the moves as irrational because losses for the past fiscal year were caused by the accelerated disposal of nonperforming loans (NPLs) and an unexpectedly sharp fall in stock prices. The FSA, however, persisted in applying the 30 percent rule, reportedly contending that, though some leeway might be given for the disposal of NPLs, it is irrelevant for banks - whose main line of business includes asset management - to count falls in share prices as a prime reason for failing to improve business performance. Indeed, it is true that the financial regulators have, until recently, tolerated banks incurring losses and refrained from applying the 30 percent rule for the sake of promoting the disposal of NPLs. Meanwhile, there is no denying that banks resorted to the old habit of following the herd. In the 1990s, it was taboo for a bank to run into the red and this hampered banks' efforts to tackle the NPL problem. Having received the virtual approval of the government to incur losses for the sake of accelerating NPL disposal, however, banks reported losses en masse. This generated moral hazard among bank managers making them feel it was OK to incur losses as long as they promoted the disposal of NPLs. Given such circumstances, it would greatly aid the reinforcing of bank governance if the FSA used this herd-mentality to its advantage and enforced the management reform of all those banks in one fell swoop. It appears, what with the progression from the announcement of the Program for Financial Revival to the recent issuance of administrative orders for business improvement, that the financial regulators are slowly but surely chasing the unwitting major banks into a corner on three fronts - stricter asset assessment, recapitalization, and reinforcement of governance. This explains why banks have reacted with outcry to these moves by the government, labeling each one an "abrupt change in the rules."

Is the reinforcement of governance enough to drastically improve banks' management? Not necessarily. Strengthening banks' governance is certainly a prerequisite for this but does not necessarily constitute sufficient conditions. Whether banks will be able to drastically improve profit performance hinges on their ability to establish a new business model. At the moment, however, it is unlikely that any of the banks have a clear blueprint for such a new business model. Of course, the regulatory authorities - those urging banks to map out a "highly profitable business plan" - do not have any blueprint either. Individual banks must work out such a plan on their own, ridding themselves of their lock-step mentality, mobilizing their wits and ideas and taking advantage of their respective characteristics.

There may be substantial adverse effects, such as those described below, if the financial regulators haphazardly urge banks to increase profits when they lack any business model or plan that will likely bring them. If a bank focuses only on profitability in lending, for instance, it would have no choice but to deal with high-risk borrowers. This would, in turn, increase the bank's asset risk. Meanwhile, if profit becomes the top priority, banks would hesitate to proceed on the disposal of NPLs. Furthermore, because banks' balance sheets are not as transparent as those of non-financial companies, it would not be so difficult for a bank to manipulate accounting figures and present them as if it had achieved certain "target figures." The working team on the public fund injection system, in its report in July, highlighted a framework for realizing the reform of bank management, under which banks are to set numerical targets and bank managers would be held responsible for the meeting of them. Given the ongoing state of the banks, however, this framework may not lead to the improvement of their overall business performance, let alone achieve the goal of avoiding losses.

The latest administrative action against the 15 recapitalized banks was a sign that Japan's financial administration has shifted quite clearly from a "discretionary" system to a "rule-oriented" or "results-oriented" system. Some might recognize the necessity of such a shift in the financial administration, but do bank managers or the general public know precisely what the government intends to achieve with its new policy? It is necessary to rethink the way in which the FSA communicates with the banking industry and the transparency of financial administration. Policy measures that would determine the fate of banks are susceptible to political influence. Should it become known that a certain policy scheme under consideration would be detrimental to banks, banking industry officials would lobby hard with ruling party politicians to prevent administrators from introducing it. Looking at the way the FSA has implemented policy measures in the past few years against the backdrop described above, we can see that the Financial System Council often lets a relevant working group deliberate substance and set a direction. However, because the minutes of working group meetings are not disclosed to the public, there is no telling what kinds of discussions have taken place until some sort of summarizing report is compiled and put forward. Moreover, even when a working group does put out a report, policy intentions tend to be left rather vague. Such a report may take the form of a "progress report" without giving any firm conclusion, as has been the case with the reports submitted by the three working groups of the Financial System Council. Or it may be the case that a certain direction for an overall framework is given, but two or more conflicting arguments are listed. Yet, it is nevertheless true that the FSA's latest administrative step strongly reflects the ideas of "numerical targets" and "responsibility for results" that are underlined in the report by the working group on the public fund injection system.

To sum up, the FSA's action against the 15 banks can be interpreted as a permanent shift by Japan's financial administration toward a rule-oriented system, and the move is greatly conducive to the reinforcement of banks' governance. However, while this would lead to stricter discipline for banks, the financial regulators themselves would not be able to personally present a "highly profitable business plan." Such a plan must be drawn up by the individual banks in their own capacity. Therefore, it must be kept in mind that banks may subordinate other goals (risk management, disposal of NPLs, etc), if financial regulators single out the improvement of profit performance and force banks to set numerical targets at a time when they have yet to establish any effective business model for drastically improving profit. In addition, though a policymaking process, especially in the sphere of financial administration, is susceptible to political intervention, financial regulators must make greater efforts to improve policy transparency so that not only the banking industry but the general public can see the consistency and continuity of the government's policy intentions.

August 11, 2003

Refer to "Administrative measures regarding the follow-ups on capital-injected banks," Financial Reconstruction Commission, September 1999, and "Clarification of the policy stance on administrative measures regarding the follow-ups on capital-injected banks," Financial Services Agency, June 2001 (this report clarified the government's stance on the disposal of NPLs).

August 11, 2003

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