Policy Update 010

Toward Reconstruction of Banks: Can Public Bailout of Resona Bank become Model Case? (Part 1) - Handling of Deferred Tax Assets and Evaluation of Financial Crisis Preventive Measures -

TSURU Kotaro
Senior Fellow, RIETI


Upon receiving notification from Resona Bank that its capital adequacy ratio had fallen to 2% as of the end of March, below the minimum requirement of 4% for domestic banks, the government held a meeting of the Financial System Management Council on May 17th and acknowledged the need to boost up the capital base of the bank. In line with this decision by the government, Resona Bank filed an application on May 30th for a capital infusion of ¥1.96 trillion along with a restructuring plan. After examining the bank's plan, on June 10th the Financial Services Agency announced the government's verdict on the recapitalization and the outline of the bank's restructuring plan.

As a specific means to recapitalizing, it was decided that Resona Bank should issue several types of preferred stocks, which are not only entitled to preferred treatment in dividends but also carry voting rights, along with common stock. The issuance of such preferred stocks was included in the recapitalization scheme because the number of newly issued common stocks is limited by law to three times the number of shares outstanding. The recapitalization scheme, under which the government injected funds through the acquisition of these common and preferred stocks, has been designed to enable the government to secure two thirds of the voting rights at the bank's shareholders' meeting. Such a controlling stake allows the government, without support from any other shareholders, to adopt special resolutions on critical issues such as the dismissal of board members or the transfer of businesses. Combining common stocks (5.7 billion shares worth ¥296.4 billion) and preferred stocks (8.32 billion shares worth ¥1,663.6 billion), the government is believed to have gained more than 70% of the voting rights. Thus, the government, as the top shareholder, has put the bank under its control (virtual 'nationalization' of the bank). In this series of two articles, I would like to examine whether the bailout of Resona Bank can stand as a model for the reconstruction of a (major) bank, reviewing the process leading up to the injection of public funds (Part 1) and evaluating the restructuring plan submitted by the bank (Part 2).

Treatment of Deferred Tax Assets: How to Interpret 'Accounting Standards'

According to media reports, the drama leading up to the 'nationalization' of Resona Bank began to unfold in May when Shin Nihon & Co., an accounting firm that audited the bank's financial statements, concluded that the bank should be allowed to recognize deferred tax assets to the amount based on its estimated taxable income for only the next three years, instead of the five years suggested for application to major banks under guidelines set forth by the Japanese Institute of Certified Public Accountants. The managers of Resona Bank reacted harshly to this decision, claiming that the accounting firm's move was tantamount to a "breach of trust." But this perception of Resona's is wrong. The JICPA guideline (Auditing Committee Report No. 66 concerning the judgment on the realizability of deferred tax assets) simply states that in the case of major banks, given instabilities in their business performance and levels of taxable income in the past, "deferred tax assets would be realizable to the amount based on estimated taxable income only for a reasonable period of time (roughly five years)." The guideline is by no means intended to guarantee that all major banks can realize deferred tax assets for five subsequent years. Also, in the Program for Financial Revival announced last year, the government pointed out the need to verify the reasonability of the assessment of deferred tax assets. In response to this, the JICPA issued a circular (concerning, "auditors' strict approach in the auditing of major banks") under the name of President Akio Okuyama in February. The president's circular reemphasized that, "deferred tax assets judged realizable as of the end of the previous year should not be automatically judged realizable at the end of the current year of auditing," and that, "the period of time for which taxable income is reasonably estimable can be shorter than five years."

That is to say, even among major banks, the period of time in which deferred tax assets are deemed realizable differs depending on the performance of the bank in question. Furthermore, it is only natural that different accounting firms may make different judgments. Given the ongoing drastic changes in the business environment surrounding banks, one must inevitably rely on his or her subjective judgment in determining the extent to which each bank should be allowed to include deferred tax assets as a component of its capital. Moreover, this creates a situation in which arbitrariness and discretion can easily come into play. Therefore, bank managers striving to ensure sound management should endeavor to clear the threshold capital adequacy ratios (8 percent for internationally operating banks and 4 percent for domestic banks) regardless of the method for calculating deferred tax assets (that is, even when the strictest criteria are used in evaluation.)

As of the fiscal yearend in March 2003, the ratio of deferred assets, as measured against the amount of the core 'Tier 1' capital, stood at 41.6% for the Mitsubishi Tokyo Financial Group, which marked the lowest ratio among Japan's seven major banking groups, while the Mizuho Financial Group, the Sumitomo Mitsui Banking Corp., and UFJ Bank all stood at around 60%. As for Resona Bank, the ratio was as high as 99.5% with its dependency on deferred tax assets up from the previous fiscal yearend. If deferred tax assets are excluded, the capital base of all of these major banks is far from sound; and even among the four mega-banking groups, some might find it difficult to maintain the capital adequacy ratio of 8%. For now, banks have been able to fulfill the minimum capital requirement by heavily relying on deferred tax assets, the inclusion of which as a component of capital is subject to discretion. This situation is both abnormal and critical.

Evaluating a company's balance sheets is no easy task. When we compare assets and liabilities, we can see that the amounts of liabilities are very much fixed and clear, but we find it hard to assess assets. In this sense, an 'asymmetricity' exists between assets and liabilities. Questions concerning the evaluation of intangible assets, book value versus market value, or the handling of tax-related items are all examples that indicate the difficulty of asset assessment. There is no single ultimate method for evaluating assets. Yet, if each company uses different asset evaluation standards, no appropriate comparison can be made. This is why domestic and international accounting standards have been set and companies comply with these standards in preparing financial statements. Meanwhile, additional difficulty stems from the characteristics of products and services provided by financial institutions. Financial products and services - unlike those handled by non-financial companies - are essentially traded on the, "promise of future payments," and thus it is difficult to judge the quality of these assets immediately. Furthermore, the absence of an effective secondary market for loans, which make up the major portion of banks' assets, makes the problem even more serious.

It is on the recognition of such difficulties in evaluating banks' assets that the Bank for International Settlements mandates the use of a risk-weighted approach - which is to assess assets in accordance with their respective risks - as an international standard in calculating a bank's capital adequacy ratio. However, even this should be regarded as only one way of thinking. Otherwise, banks' activities may be distorted as a result of putting too much emphasis on the clearing of BIS standards. For instance, banks with impaired capital would want to include a greater amount of deferred tax assets in its core capital in order to prevent its capital adequacy ratio from falling below the level required under BIS criteria. Or they could be motivated to hold their assets in the form of government bonds - which can be treated as risk-free securities - to an amount exceeding an optimum level. These short-sighted moves, however, would further weaken a bank's capital base. Bank managers, while following the accounting standards and principles, should not take them as rigid rules with which they must comply by any possible means. What is more important is for them to renew their recognition of the basic accounting principle of conservatism, that is, to use stricter evaluation in asset assessment when subjective judgment comes into play.

Potential 'Financial Crisis': Was the Implementation of Preemptive Measures Appropriate?

The recapitalization scheme for Resona Bank was implemented in line with Article 102-1-1 of the Deposit Insurance Law. This means that the government acknowledged the, "possibility that the credibility of financial systems in Japan, or in an area where Japanese financial institutions operate may be significantly impaired." Accordingly, the government held a meeting of the Financial System Management Council to reconfirm that the situation constituted a case in which the government should implement measures to recapitalize a solvent bank under the above article of law; not Article 1-2 under which deposits at a failed bank would be fully protected, nor Article 1-3 that that provides measures for the liquidation of a failed bank. According to remarks by government officials made before the Diet or elsewhere, significant withdrawals of deposits, a plunge in stock prices, a major credit crunch, and the possibility of a chain reaction are examples of events indicating a, "significant impairment of the credibility," of the financial system, and hence a precondition for recapitalizing a solvent bank. In the recent case of Resona Bank, however, none of these events have occurred as has been acknowledged by the financial authorities. When a bank's capital adequacy ratio falls below the 4% threshold considered sound for a domestic bank, the government is supposed to take prompt corrective actions. But for Resona Bank, the government skipped this step and immediately considered the infusion of public funds. Financial Services Minister Heizo Takenaka said that the government's move was intended to, "preempt a financial crisis because a major problem may occur if the situation is left unattended."

With regard to Resona Bank, it is quite conceivable that the government feared that serious events, such as those described above, might have occurred if depositors or market players had overreacted and public distrust in other banks had deepened; and that prompt corrective actions, even if invoked, might not have been enough to prevent this. Particularly, given the ongoing stock market slump, it is no wonder that the government feared a further plunge of stock prices led by steep falls in bank shares, or the collapse of a life insurance firm which holds a massive amount of bank shares under an inter-group cross-shareholding arrangement. Also, because Resona has a higher ratio of loans to small and medium-sized enterprises (SMEs) in proportion to total outstanding loans, compared to the loan portfolio of other major banking groups, the government must have been afraid that Resona, if left unchecked, might have dashed to squeeze lending to SMEs in order to reduce assets, and would have caused serious damage to the economy of specific areas that have been the prime operational base of the bank, namely, the Kansai region. However, it is questionable whether or not the government sufficiently examined the degree of this possibility or probability, and then estimated the specific scale of expected damage (and compared this to the cost of injecting public funds) before deciding on the scheme. The government sought the legal basis of implementing the preemptive scheme in provisions made under the Deposit Insurance Law referring to the, "possibility that the credibility (of financial systems) ... may be significantly impaired." In doing so, the government cannot escape criticism for stretching the interpretation of the law, even though the necessity of a policy framework for such preemptive measures is acknowledged.

It is worthwhile reexamining whether an audit by an independent auditing firm - in particular, its 'conclusion' on the treatment of deferred tax assets, which is often open to subjective judgment - can be a viable 'trigger' or provide 'foundation' for invoking significant government policy leading to substantial burden on taxpayers. Should it be the case that the government's action regarding Resona was prompted solely by Shin Nihon's judgment, then there would have been no need to take the preemptive measures if only the auditing firm had let Resona book deferred tax assets for five years, just like other major banks did. On the other hand, some other major banks - those heavily dependent on deferred tax assets - might have failed to clear the threshold capital adequacy ratio, had they been urged by their auditing firm to calculate the amount of deferred tax assets based on the same, "period of time for which taxable income is estimable," as was applied to Resona. Taking this line, it could be said that the government should have initiated recapitalization measures on all such banks, from the standpoint of preempting a possible crisis.

The ongoing situation itself is not an outright 'financial crisis'. But this is a situation in which a 'financial crisis' is being forcibly contained so as to not let it surface. A potential 'financial crisis' has been growing underneath, and no matter how hard we try to keep the lid on it, the germ of crisis will eventually find its way and come to the surface. Furthermore, because this germ will evolve into a full-fledged crisis, if left alone, it must be eliminated before it gets too late. This probably explains why the government took preemptive measures this time round.

But I believe that the government need to take a more proactive and comprehensive approach in tackling the existing potential 'financial crisis', instead of just covering up the problem and waiting until the crisis surfaces. The use of such a drastic policy is not at all unrealistic considering the likelihood of stricter treatment of deferred tax assets as described below.

Stricter Evaluation of Deferred Tax Assets and Drastic Policy to Preempt Crisis

At the last fiscal yearend in March 2003, all the seven major banking groups reported losses as they, all in all, accelerated nonperforming loan (NPL) disposals - substantially raising the loan loss coverage ratio for risk-managed loans, taking actual losses on the legal liquidation of troubled borrowers, and selling loan assets to the Resolution and Collection Corp. (RCC) - in response to the government's Program for Financial Revival. Bank managers probably did not have to gather too much courage to announce these losses as they expected others would do the same, and this would be just another example of typical Japanese herd-mentality, or as the saying goes: "safety in numbers." But the JICPA guideline says that no realizability of deferred tax assets should be recognized for, "companies that have reported material taxation losses for roughly three years or more in a row in the past and expect another significant taxation loss for the reporting year." Therefore, at the next fiscal yearend, other major banks might also be forced to evaluate assets more strictly. There can be no ruling out a scenario in which an internationally operating bank, failing to achieve the minimum capital adequacy ratio of 8% due to the erosion of deferred tax assets as a component of capital, will be forced to drastically consolidate assets by withdrawing from overseas operations. In any case, the handling of deferred tax assets will once again be a determinant factor in deciding each bank's fate. But I do hope that such a dire prospect will serve as leverage for bringing about the implementation of drastic bank revitalization measures.

>> Original text in Japanese

June 16, 2003

June 16, 2003

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