A Tough Regime for Rescuing Japan’s Banks

Is there any course of action the Japanese can take that will restore health to the country’s financial system–a necessary prerequisite for resumed growth of the economy–but not threaten a financial panic? Fortunately, the answer is yes.

Here is how:

* Bank supervisors should perform honest triage, using the best estimates that they can develop about likely losses to decide which banks must be closed or merged and which should remain in business. In making their estimates, the authorities should err on the side of putting banks out of their misery rather than praying for their resurrection.

We in the United States learned this lesson at great cost during the savings and loan crisis, when we let hundreds of solvent thrifts that “officially” looked healthy gamble their way to more than $100 billion in losses and let many weakly capitalized banks take risky bets on commercial real estate that took the banks years to recover from.

* Japan should copy what U.S. policy makers did after the thrift and banking debacles in 1991 and introduce a system of “prompt corrective action.” Under PCA, regulators are required to take progressively tougher measures to constrain the behavior of banks with less than the minimum standard of capital. In the Japanese context, this means telling weakly capitalized banks that are permitted to remain in business either to raise additional capital on the open market or to quit growing until they do.

* Japanese banking supervisors should offer the insolvent banks to potential buyers as “clean banks”–with all their deposits and only those good assets that buyers want to acquire, together with government bonds to make up the difference. The Japanese equivalent of our Resolution Trust Corp. should take the “bad assets”–generally the real estate that backs uncollectable loans–that the buyers may not want. All buyers must meet the minimum capital standards. These steps will protect depositors (and thus avoid a financial panic) but will also wipe out the shareholders and clean out the managers of the failed institutions. This is necessary and will make it easier for Japanese politicians to defend the plan to voters.

To maximize the number of Japanese bidders, the authorities should permit any healthy financial enterprise–bank, securities firm or insurer–to bid. As a practical matter, only foreign banks may be sufficiently healthy to bid, but if that turns out to be the case, then so be it. In theory, Japan could take the bolder step of allowing its commercial companies to bid as well, but this may raise concerns about excessive concentration of economic power similar to those being raised about our own financial reform efforts now being debated in Congress.

Admittedly, this plan could drive more than a trillion dollars of assets into the hands of an RTC. But this may be the only way for Japan to begin moving the large volume of real estate that now lies frozen in bank balance sheets and that otherwise is difficult to sell because of the tax liabilities that such sales trigger. When the government sells the assets, it need not worry about paying taxes. Meanwhile, the more quickly this real estate is sold, the faster it can be put into more productive uses.

Should the authorities be worried about selling at fire sale prices? Yes, but they can minimize the damage by giving the RTC discretion to change zoning restrictions that may artificially hold down prices.

* Japan should be bold without further delay. Prompt, decisive action will restore the confidence of domestic and foreign investors alike in the government and in the economy. This is necessary not only for Japanese residents but also for the health of the larger Asian region.