Trichirapalli Draft 1

Japanese Economic System –Rise and Fall

Economy and Bank nature:

The American economy has become more dependent on securities than on bank loans for business finance .In large measure because of pension funds and mutual funds, more than half of American households are estimated to be shareholders in one way or another. America's financial industry is the world's undisputed leader in innovations in the areas of derivatives and securitization, all adding to the rapid growth of the securities market. In these respects, American capitalism can be appropriately called "securities-market capitalism."

In contrast, Japan's financial industry, although it was actually remodeled on the American system after World War II, has been sui generis in many respects. It is dominated by banks to such an extent that Japanese-style capitalism can be characterized as "bank-loan capitalism," especially in light of the relatively insignificant role played by the corporate bond market. Bank loans have been critical in financing Japan's phenomenal economic growth in the postwar period. Bank loans were majorly provided to manufacturing sector.

US private banks are true for-profit institutions. Individual and institutional shareholders appoint managers to oversee day-to-day activities. In this sense managers are accountable to bank stockholders. They must enhance stockholders wealth. At the same time they must limit traditional risks (liquidity and credit), market risk and operational risk.

In contrast, Japan bank are not true for-profit institutions. Bank stockholders appoint managers to oversee day to day activities; but have little control over it. Banks operate under what is known as keirelsu – relations are not too concerned with profits, but rather with relations and mutual obligations with other keirelsu members. In the form of relational banking, banks serve more as corporate welfare agencies, providing low cost financing to their keirelsu clients who are also their shareholders as compared to other clients instead of true profit maximizing enterprises. Japanese banks are not overly concerned with traditional banking risks either. Under a policy known as ‘overlending’ Bank of Japan has virtually eliminated liquidity risk.

Rise of Economic System:

When banks are operated in this style, relaxation activities are gradually introduced during the first of half of 1980s so that the liberalization of the financial system in Japan would help address the strong US dollar problem by stimulating demand for yen denominated instruments. Deregulation of capital markets including the lifting of the prohibition on short-term euro yen loans to domestic barrowers happened in 1984. Interest rate controls are relaxed starting with liberalization of term deposit rates in 1985.

Gradual removal of restrictions on access to corporate bond market and the creation commercial paper market in 1987. These developmental factors significantly strengthened the ability of large corporations to borrow directly from the market. Restrictions are relaxed on permissible activities of previously tightly segregated institutions, including the raising of different types of lending ceilings. These developments had important consequences for banks and other finacial institutions. Financial liberalization in the 1980s allowed small financial institutions to venture into new areas, particularly funding housing finance companies (Jusen) and other real estate investments.

This development along with other deregulation, e.g. lifting of interest rate controls and of restrictions on non-bank lending, intensified competition among financial institutions and depressed interest rate spreads. In response, banks expanded into riskier lending, such as consumer loans, real estate loans, and small business lending, where the regulatory and supervisory framework proved to be inadequate. Deregulation of capital markets allowed large firms to increasingly shift away from banks to domestic and euro bond markets for funding (Hoshi and Patrick 2000).

This shift induced major banks to increasingly channel their loans towards firms without sufficient access to domestic and international capital markets. As a result, the composition of bank clients changed from manufacturing to non-manufacturing firms and from low to high credit risk borrowers. Banks extended too many loans to firms in the real estate, construction, distribution, and finance sectors, which had been insulated from market competition, unlike those in the manufacturing sector, and hence had been less efficient, less productive and riskier.

Expectations of high economic growth allowed further expansion of collateral-based loans under the general conditions of low interest rates and inadequate prudential supervision by banks. Prudential supervision was inadequate—leading to limited public disclosure of financial data, insufficient loan loss provisioning, and undercapitalization—and commercial banks had not developed a credit culture allowing the rigorous assessment and pricing of credit risk that is so necessary for sound banking.8 Collateral-based lending weakened banks’ incentives to closely monitor borrower firms. The late 1980s saw an expansion not only of bank loans but also of capital investment and labor employment.

They sharply increased their consumer lending and lending to the real estate industry and to small and medium sized enterprises. Meanwhile, the persistent focus of banks on market share and the fact that their lending decisions were primarily based on collateral requiremnets rather than on cash flow analysis caused the banks to loosen credit standards as real estate prices started to climb. To speed up credit check procedures for loan approval, banks transferred the responsibility for loan risk evaluation from their credit investigation bureaus to less independent monitoring bureaus that reported directly to the banks’ sales divisions.

All these actions attracted many small financial institutions and banks to lend loans to housing finance companies and realestate investments. This cause a huge increase in real estate property values and stock prices.

Fall of Economic System:

Absence of a credit culture to assess and price credit risks of borrowers aggravated by weak prudential and supervisory frameworks paved way for the economic collapse of Japanese banking system.

The bubble burst once the authorities sharply tightened their monetary policy—by raising the interest rate—and introduced credit ceilings on real estate-related bank loans in 1990-91. The bursting of the bubble and the subsequent collapse of stock and land prices created the triple excesses of debt, capacity and labor—by transforming (a) much of the overextended loans into non-performing loans (NPLs) on the part of banks and (b) a large build-up of capital investment and employment into excess capacity and employment, respectively, on the part of firms.

All of these exerted a severe negative impact on the economy and the banking sector. Land price deflation, which continued throughout the 1990s and early 2000s, was particularly damaging because it substantially eroded the collateral value of bank loans. The bursting of the bubble created substantial losses for firms that received loans from banks with real estate collateral because of sharp declines in the property price. As a result these highly indebted firms became unable to repay their loans, creating NPL problems for commercial banks. The asset price collapse also left problems with banks initially by wiping out hidden capital gains on their equity holdings, secondly by transforming certain corporate loans into non-performing loans. In response commercial banks became reluctant to extend loans to corporate borrowers and even began withdrawing existing loans from their borrowers.

Banks did not attempt aggressively to resolve their NPLs at the early stage partly because they valued highly the maintenance of good bank-firm relationships and partly because the regulatory framework was not stringent, thus postponing the ultimate resolution of NPL problems. Nonetheless, commercial banks began to dispose of NPLs in the early 1990s, initially at a
gradual pace and later at a faster pace. With asset price deflation and weak economic activity, new NPLs continued to emerge throughout the 1990s and early 2000s. When price deflation began to embed itself in the economy in the second half of the 1990s, it became even harder to stop the emergence of new bank NPLs despite the banks’ efforts to dispose of existing NPLs

The incipient price competition, which was beginning to place a downward pressure on banks’ risk-adjusted interest rate margins, led them to expand riskier segement of their loan portfolios. The effect of the bad debt crisis has paralyzed Japan's financial sector, and with it the larger economy. The Japanese government spent some 75 trillion yen ($556 billion) on "pump-priming" public works projects during 1990s and interest rates have dropped to historic lows - the current short-term interest rate is only 0.62 percent - but still economic activity remains anemic. From 1992 to 1997 economic growth in Japan averaged only around 1 percent a year, compared with 2.9 percent in the United States and just below 3 percent for the world. The economy actually shrank 0.7 percent in 1997, and with two consecutive quarters of negative growth, Japan was officially in a recession for the first time since 1975.

Other statistics paint an equally bleak picture. Corporate bankruptcies were up 37.5 percent in May 1998 over the same month the previous year, and personal bankruptcies may exceed 100,000 this year, compared with 70,000 last year. The yen slid to an eight-year low against the dollar in June 1998, prompting official government intervention in the currency markets. Unemployment - historically low in Japan - has reached its highest point in decades. It hit 4.1 percent in June 1998, according to the Japanese government.

http://www.imf.org/external/pubs/ft/wp/2000/wp0007.pdf
http://www.kellogg.northwestern.edu/finance/faculty/seminars/Xueping_Wu_11-3-05.pdf
http://en.wikipedia.org/wiki/Japanese_financial_system

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