Policy Update 002: Assessment of the Government Program for Financial Revival and the Challenges Ahead: Comprehensive Package of Counter-Deflationary Measures Unveiled Oct. 30

Expansion of tax-free provisioning is bound to further delay the disposal of nonperforming loans

Consulting Fellow, RIETI


On Oct. 30, the Financial Services Agency unveiled a Program for Financial Revival that includes measures to expand "tax-free provisioning" of nonperforming loans (NPLs). The measures are in response to bank requests that Japan should permit more tax-free provisioning of NPLs, as write-offs are purportedly in the United States. However, this makes no sense. In truth, almost all Japanese people confuse "write-offs" with "provisioning" for possible losses on NPLs. Of course, tax-free provisioning is not allowed in the U.S., and the expansion of such provisioning is bound to delay bank disposal of NPLs.

"Shokyaku" in Japanese can mean two different things: provisioning and write-offs.

To begin, I would like to emphasize that the use of word "shokyaku" in Japanese tends to cause confusion. As a typical procedure for disposing of NPLs, a bank would first report estimated loan losses as loan loss provisions, a liability (contra-asset) account, on a balance sheet (disposal of NPLs in terms of monetary value). Then, when the amounts of actual losses are determined - for instance, by auctioning off collateral - the bank writes off the NPLs directly, eliminating the loans from the asset section of the balance sheet (disposal of NPLs themselves). In English, the differences between the two stages are clear in the terminology. When a bank sets aside a certain amount of money for possible loan losses, that amount is reported as "provisions," an expense item, on a statement of profits and losses. The accumulation of such funds is called "allowance" or "reserve" for loan losses and appears on the balance sheet. Write-offs are simply referred to as "charge offs."
In Japanese, however, we call provisioning for certain loans - specifically those classified as Category III (loans likely to incur losses) and Category IV (loans deemed unrecoverable) - "kansetsu shokyaku," and the word "shokyaku" generally includes both provisioning and write-offs. In conversation with Americans, the Japanese word "shokyaku" is often translated "charge-offs" or "write-offs." But when we say "indirect write-offs" - meaning "provisioning" - confusion results. We need to use either "provisions" or "allowance," depending on whether we are talking about figures on a statement of profits and losses or on a balance sheet. Likewise, using the Japanese term "shokyaku" when referring to "charge-offs" and "write-offs" in English is misleading, because Japanese people are most likely to interpret the word "shokyaku" as provisioning, not write-offs. The English term "write-offs" should be translated into the Japanese "chokusetsu shokyaku," not "shokyaku."

No tax-free provisioning in the U.S.

In the course of debates running up to the compilation of the government's counter-deflationary package, representatives of the banking industry insisted that tax-free "shokyaku" is easier in the U.S. and that U.S. taxation authorities allow banks to deduct loan losses from gross profits once banks conclude the loans in question are uncollectible. Because those arguments were voiced in the context of tax effect accounting, what was referred to as tax-free "shokyaku" apparently means tax-free provisioning. Thus, this amounted to a demand that provisions for NPLs be treated as losses for taxation purpose. This particular measure has been included in the government's Program for Financial Revival. Under the title of "Introduction of a new tax measure enabling provisioning to be recognized as tax-losses," the program states that "The FSA will request a tax treatment that enables provisioning to be recognized as tax-losses, with regard to provisioning to the borrowers classified as "in danger of bankruptcy" or below as a result of bank self-assessments under the supervision of and inspection by the FSA."
But based on what I understand concerning the U.S. banking industry, provisioning for loan losses, although treated as an expense for the purpose of financial accounting, is not recognized as losses for taxation purpose (i.e., taxable) and losses on NPLs are deductible (i.e., nontaxable) only when banks write them off directly. (See charts below.) Simply put, tax-free provisioning is not allowed in principle in the U.S. Banks must write off NPLs directly to make losses deductible. This is because the amounts of loan losses are always estimates at the stage of provisioning, and cannot be treated as losses to calculate tax amounts, which must be calculated based on fixed amounts. When NPLs are written off directly, the amounts of loan losses will be finalized and treated as tax losses.
Why do so many Japanese hold this misconception of tax treatment in the U.S.? I believe this is due to the translation of "write-off" as "shokyaku," which leads people to construe "shokyaku" as "provisioning."

Taxable provisioning helps promote write-offs

The combination of taxable provisioning and nontaxable write-offs in the U.S. appears to be designed to provide tax incentives for lenders (financial institutions) to write off NPLs quickly. However, such tax incentives do not constitute special treatment. From the lenders' point of view, what they had already recognized as losses for financial accounting are simply being recognized as tax losses after completely disposing of NPLs. What would happen if the Japanese taxation authorities permitted the recognition of tax losses at the stage of provisioning as requested by the banking industry? Banks would use up their tax incentives in setting aside loan loss reserve funds, leaving little incentive for write-offs. In reality, banks are allowed to make greater deductions at the stage of provisioning in Japan than in the U.S. And this may be one reason why the true disposal (write-offs) of bad loans has not proceeded smoothly in Japan. Thus, providing tax incentives for disposing of NPLs in terms of monetary value as with tax-free provisioning will likely cause further delays in physically disposing of NPLs. But it is also true that the physical disposal of NPLs will not proceed unless disposal in terms of monetary value makes progress. Then, given the current situation of Japan's NPL problems, can we consider the possibility of providing certain tax incentives for provisioning as a way to accelerate NPL disposals in terms of monetary value? The answer is "No," and I believe no such incentives are necessary. The reason is a recent court judgment that ruled a bank's failure to properly set aside provisions for NPLs as illegal.

Insufficient provisions may be regarded as window-dressing

In a ruling on Sept. 10, the Tokyo District Court convicted three former executives of the failed Long-Term Credit Bank of Japan (now reborn as Shinsei Bank) of window-dressing and violating the Commercial Code. The ruling condemned their failure to set aside appropriate loan loss reserve funds as an illegal act, not a matter of misjudgment by management. Furthermore, the ruling says that provisions must be reported as a lump sum. In other words, any accounting losses on NPLs must be expensed in each business term in which they were incurred, thereby automatically eliminating NPLs at each term end. As long as banks dispose of NPLs in such a manner, any NPL problems would be solved gradually. Although some friction might result, they would not grow into critical issues. The fact that the problem of NPLs remains unsolved in Japan means that Japanese banks have been continuously failing to set aside sufficient provisions for NPLs. In the past 10 years, we have heard bank executives publicly say, "We're doing everything we can to resolve our bad loan problems," or "We plan to complete the disposal of bad assets in X number of years." In light of the latest ruling, these remarks appear quite problematic.

Automatic provisioning under statutory requirement plus tax incentives for write-offs

As indicated by the ruling, NPL disposals in terms of monetary value should be automatic, with no exceptions or extralegal treatment. Creating and working in accordance with a plan in disposing of NPLs in the context of corporate financial accounting may be taken as mere window-dressing. At the end of September, Japanese banks must have disposed of massive amounts of NPLs. Theoretically, all of the disposed loans must have been newly incurred in the six-month period then ended. But I wonder just how many bank executives can declare that this is the case. In any case, no special incentives are required to dispose of NPLs in terms of monetary value, as the possibility that bank executives may be convicted if they fail to set aside provisions as required by law would be enough. Then, we can provide tax incentives for write-offs (no special treatment, but a result of a time gap between financial accounting and taxation), leaving the actual resolution of problems to negotiations among the concerned parties. It is often said that there are two methods - a hard landing or a soft landing - to resolving the NPL problem. But as long as we stick to such perceptions, debate will be fruitless. Disposal of NPLs must be carried out as matter-of-factly, in accordance with statutory requirements - neither a hard nor soft landing - and tax incentives should be provided only in the final stage.

reference chart

>> Original text in Japanese

November 14, 2002

November 14, 2002