Trichirapalli Final

Japanese Banking System - Rise and Fall

Executive Summary:

Japan had an economic system where banks provide funding to major business corporations for their business credits. Even though the banks held a smaller percentage of stocks of the company, they were engaged in the corporation’s regular activities and were participatively watching the performance. Regular share holders believed the bank and let the bank to be a watching superior authority on companies’ performance. Banks mostly loaned their money mostly to manufacturing companies instead of concentrating on derivatives.

During mid 1980s the focus changed drastically and banks started to loan money for real estate properties and collaterals. This approach was initiated by the action of stimulating Japanese Yen in the world economy to strengthen yen against US dollars. As the Government relaxed certain regulations, more financial companies entered into the picture. Banks have to competite with each other to capture more market share and started to follow different procedures to capture more customers. Many players lent money without backing surety or proper valuation. This has eventually resulted in a false appreciation of real estate property values and stock market boom.

When the regulations are brought in by the form of ceiling control on loan amount and higher interest rate, most of the assets which are valued higher could not bear this situation and the system collapsed. Most of the loans issued without proper guidance became non-performing loans. Government intervened into the system and injected huge cash into the system. More regulatory procedures are implemented and small banks are merged together with bigger reliable banks for stabilization. After more than a decade, system got stabilized and the performance does not go to the negative side and maintained in a positive growth.

Traditional Japanese Banking System:

Before World War II, majority of Japanese business sector was dominated by powerful business companies called Zaibatsu. Each Zaibatsu owned a family bank and number of business corporations. The bank controlled equity capital for those business firms. After the war, Zaibatsu system was dismantled to avoid building economic power to individuals and all of them were nationalized. For financing their business activities, business corporations relied heavily on bank credit due to the slow development of bond and debenture market. This development behavior ended up in a system called “main bank” in which a single bank provided the largest share on a companies’ credit. The bank acted as a collaborator and consultant.

In this style of functioning, the relationship among shareholders was smooth in majority of the Japanese corporations. There was an implied understanding among stakeholders that they had a strong faith on the main bank. They counted main bank as a protecting agent that keep a close watch on the corporation’s performance and behavior. At the same time, main banks truly acted for the protection of shareholders’ interest and verified the corporation’s business growth and stability. Banks had a cordial relationship with companies while only accounting for 5% of the corporation’s share. The relationship is not based only on shareholding; but also on credit, personal exchange, sharing of information and historical relationship11. As long as the Japanese market remained a closed entity in the world economy, the Japanese system functioned effectively to ensure stability and enable efficient mobilization and allocation of financial resources.

Difference between American banking system to Japanese system:

Nature of American economy is such that it uses a small percentage of bank loans when compared to the percentage it depends on securities for business finance. Most of the American households could be categorized as shareholders because they participate in pension funds and mutual funds where the funds are invested in stocks. America’s financial industry has an acknowledged recognition in finding new procedures in the areas of derivatives and securitization. This style ended up in rapid growth of 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 based on the American system after World War II, has been unique in its characteristics in many respects. It is dominated by banks for their business credit need to a larger portion. Banks have regular involvement in reviewing the business activities. So, 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. Majority of the bank loans were 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 like liquidity and credit risks, market risk and operational risk.

In contrast, Japan banks 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 keiretsu – relations are not too concerned with profits, but rather with relations and mutual obligations with other keiretsu members3. In the form of relational banking, banks serve more as corporate welfare agencies, providing low cost financing to their keiretsu clients who are also their shareholders as compared to other clients instead of true profit maximizing enterprises. Each bank had great control over the companies in the keiretsu and acted as a monitoring entity and as an emergency bail-out entity. Japanese banks are not overly concerned with traditional banking risks either. Under a policy known as ‘over lending’ Bank of Japan has virtually eliminated liquidity risk.

Rise of Economic System:

Japanese Government built their banking system as the main source for financing the business corporations. This method made banks as the key player and more dependable source. For that purpose and to maintain stability of the system by protecting the banks, the so-called ‘convoy system’ was put into operation. Government developed barriers to entry into the banking sector through this system. The interest rate limits are set to low on mostly all financial assets, which acted in one way as an attractive business practice. The Government also restrained the development of the stock and bond markets. The rise in entry barriers especially referred to the city bank status, which kept the number of city banks quite small, and besides this, the low interest rate ceilings constrained competition among banks.

After the oil crisis in 1970s, foundation of the Japanese main-bank system has been upset as it was operated in the regulated high growth environment. In fact, the oil crisis signaled a turning point in the operation of the domestic Japanese banking system. The effect of the oil price increases was that the economy contracted for the first time in the post-war period. From around 1975, many industrial firms looked different ways to adjust to this slower economic growth by the way of restructuring assets and reducing their dependency on bank for borrowing money. This slower economic growth and increasing social security, started to reflect in economy as government began to run deficits. But under the old regulatory system banks and other financial institutions informally agreed to hold low-yielding government debt. This has become a problem and it was impossible to finance these deficits. In an attempt to solve this problem, and to be able to finance the government deficits, massive government bond issues were necessary, which were brought about by deregulation of interest rates and the creation of a secondary market for government debt7.

The introduction of secondary market trading marked the beginning of an era of deregulation; the control over interest rates were ended, banks and other financial institutions were allowed to enter each other’s segmented markets, and not only secondary markets for national bonds were deregulated, but also the private bond market and foreign exchange markets were deregulated, leading to closer integration with international securities markets. Collectively, the trends of deregulation and globalization of world financial markets led to the fact that large industrial firms started to utilize direct financing methods both domestically and abroad, instead of bank borrowing. The trend of bank debt to all Japanese manufacturing firms is shown in figure below.

Figure 1: Bank debt / Total debt (All manufacturing firms listed in the Tokyo Stock Exchange)
Source: Hoshi, Kashyap and Scharfstein (1993)

When banks have started to operate 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 also help to 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 19841. Interest rate controls are relaxed starting with liberalization of term deposit rates in 1985.

Because of the reduced bank borrowing by large industrial firms, banks began searching for new business opportunities and engaged in increased lending to real estate development companies and to non-bank financial intermediaries which in turn lent for real estate speculation, and to industrial companies for their financial and real estate speculation. During the 1980s, this led to a spectacular rise in real estate prices and stock prices and to a superior performance of the Japanese economy.

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 financial institutions. Financial liberalization in the 1980s allowed small financial institutions to venture into new areas, particularly funding housing finance companies and other real estate investments.

This development along with other deregulations, 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.8Collateral-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 requirements 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.

Results of the change in system:

All these so called liberalized and deregulated environment actions attracted many small financial institutions and banks to lend loans to housing finance companies and real estate investments. This causes a huge increase in real estate property values and stock prices. Japan experienced a huge increase in the house prices between 1984 and 1990. Value of Japanese yen appreciated against US dollar. Japanese stock exchange Nikkei index was tremendously increasing and it reached a peak of 39000 points in 1990. Real estate values were the highest comparatively to any period. These results made everyone to believe that the deregulatory actions are helping the economy and bringing more values with huge positive growth. Functioning and borrowing style of even major corporations have started changing. They started relying and financing more on stocks, domestic bonds, external bonds and commercial papers with huge magnitude as against the traditional method of getting it done through bank loans. All these results are shown below in the charts.
Figure 2. Japanese Yen movement
Figure 3. Sources for Japanese corporate financing
Figure 4. Japanese real estate price and stock index behavior

Fall of Economic System:

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

Capital market deregulation that resulted in the lifting of prohibition on short-term euro yen loans to domestic borrowers and removal of restrictions on access to corporate bond markets encouraged companies to borrow directly from the market. And the relaxation of restrictions on the activities of tightly segregated institutions such as investment banks and life insurers made it possible for different institutions to lend to those people to whom these loans were previously denied. It resulted in a flush of funds into the market and created intense competition among different banks that were not competitors before.

Figure 5. Japaense asset price with GDP

Asset prices zoomed during this bubble mainly due to the near zero inflation and high economic growth rate, which characterized Japanese economy during that period. These two factors substantially reduced the risk premium on Japan, which made the Japanese corporations rush to the international markets for their capital expansion. The Japanese banks preoccupation with market share led them to loosen the credit controls that resulted in reckless lending. To speed up the loan approval process, banks transferred credit appraisal and monitoring to less independent units within the banks that reported directly to sales departments in banks.

This significantly eroded the value of the collaterals on which banks lent heavily during the bubble. As the prices of properties fell by half, the quality of bank assets declined drastically. Slowdown in the economic growth put pressure on the loan servicing of the debtors. These circumstances led to the downgrading of the banks by the international credit rating agencies. This was a major blow to the Japanese banks, which until then enjoyed better credit rating than their borrowers. In addition to this, restriction on the access to domestic and foreign bond markets was also lifted. As a result, there was a significant increase in the debt borrowings by the Japanese corporations.

Japanese banks made lesser provisions for losses, and they were suitably aided by the lax accounting norms. It resulted in creating very little provisions against possible non-performing assets. This proved to be a major detriment for them after the bubble burst. As the asset prices increased, banks earned massive profits and so did real estate developers, brokers and other clandestine groups such as Yakuza. The expectations that the Japanese stock exchange would bounce back were further diminished when the gulf war broke out in 1990. These events caught financial institutions and banks unaware, and it demanded a comprehensive and coordinated effort on the part of the government and financial institutions, which did not happen. This added further chaos in the already troubled Japanese banking system. In order to bring the system into control authorities implemented a sharp increase in interest rates and the introduce credit ceiling on bank loans to real estate-related activity. These activities led to the bursting of the asset price bubble.

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 segment 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. It took more than a decade to bring it back to lower number.
Figure 6. Japanese unemployment data
Figure 7. Japaense bankruptcy data

Stabilization efforts:

Japanese government took lot of steps to bring their economy back to control5. They are,

1. Stabilization of the Banking System9
Government provided emergency liquidity assistance to banks that got into trouble. They carefully selected viable banks which are weak and injected huge capital. Financial institutions were encouraged and provided with financial assistance when they found a way to survive by mergers. Some banks are temporarily nationalized as a stop gap measure. Government also provided guarantee for deposits.

2. Bank Restructuring
Large portion of the non-performing loans were identified and recognized. Then these loans are dealt for faster disposals with tighter loan classification and loan loss provisioning. Close to 90 trillion of bank NPLs were disposed; it took more than 10 years as new NPLs are discovered in this period. Inefficient institutions taking deposits were removed from the system. Public recapitalization is established in the form of public asset management companies which encouraged reducing NPLs.

3. Bank Business Strategies and Consolidation
Consolidation of city banks into four major financial groups and the strategic objective is set to gain maximum market power in a niche market and attaining economies of scale. They were encouraged to invest in IT.

4. Linkages with Corporate Restructuring
Three frameworks to accelerate corporate restructuring are implemented. New Civil Rehabilitation law is enforced which dealt with legal insolvency procedures. A new framework of voluntary out-of-court negotiations for corporate restructuring, based on the London rules of INSOL, including debt-equity swaps is implemented. Restructuring efforts were handled through RCC (Resolution and Collection Corporation) and IRC (the Industrial Revitalization Corporation).


The main root cause for the system failure is due to the lack of cautious risk management of banks. Banks have entered into a competition with expectations of high economic growth and without robust corporate governance. When the crisis happened in 1990, the government failed to tackle the problem immediately because of underestimating the problem and optimistically expecting the growth continuation.
Once they realized the problem more comprehensive bank restructuring framework was put in place. Temporary nationalization and subsequent sales of non-viable banks have been reviewed and effected. Tighter bank regulation and supervision have been implemented. Sufficient progress has been made due to stabilization effort on the banking system, restructuring and consolidation of bank businesses and new incentives for corporate restructuring. Even though the Japanese banking system came out the crisis and performing better adequate capital base should be maintained for sustaining the healthy banking system.

Final point to mention:

The chart below compares what happened in US in the recent economic crisis and the behavior of real estate prices. The pattern seems to be very similar and some of the mistakes done by Japanese banking system in late 1980s is repeated in US, like issuing huge loans based on collaterals. Surge and drop in real estate property values behaved in the same way, with a different magnitude. The result is, the US government stepped in and injected huge cash to maintain cash flow to rescue banks from falling. This has also happened in the Japanese system. Better bank management with focus on core competency and with careful risk management will keep the system in a healthy environment; failing of which is going to cause damaging pain – only to common public.
Figure 8. Similarity in US and Japanese real estate price behavior


1. Japanese Banking Crisis of the 1990s: Sources and lessons
2. Economist draws parallels between US and Japan banking crisis
3. Banking crisis in Japan
4. The Japanese banking crisis in the 1990s
5. The financial crisis in Japan during the 1990s: how the Bank of Japan responded and the lessons learnt
6. The Japanese banking crisis of the 1990s
7. A primer on the Japanese banking system
8. Japan on the track of world’s #1 economy
9. Japan’s banking system: From the bubble and crisis to reconcruction
10. The changing Japanese banking system
11. The Japanese banking system
12. Understanding the rise and decline of the Japanese main bank system:
13. Japanese financial system

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