In November 1996, Prime Minister Ryutaro Hashimoto, borrowing rhetoric from the 1980s deregulation of London’s financial markets, called for a “Big Bang” deregulation of his country’s financial markets to be completed by 2001. Japanese governments have trotted out various regulatory reform measures over the years, with mixed results at best. Is this time any different?
Certainly the fanfare surrounding the announcement of the Big Bang would lead one to believe the answer is “yes.” Indeed, measured against the limited results of past Japanese deregulation initiatives, the new proposals are indeed ambitious and represent a welcome movement by Japan toward freer capital markets. But the ultimate impact of Japan’s Big Bang will be limited by its place in a national economy that remains elsewhere highly regulated – and in a society that in many ways remains hostile to deregulation.
Until the late 1970s, Japan’s financial markets were, like the rest of its economy, highly regulated. The overall financial system intentionally favored banks, the banking sector was finely segmented, banking and securities firms were strictly separated, virtually all interest rates were controlled by the government, foreign exchange was tightly controlled, and the variety of financial instruments of all kinds was limited and subject to approval by the Ministry of Finance. Monetary policy tended to operate through quantitative measures (varying the supply of central bank credit to the commercial banking system) rather than interest rate manipulation. And with interest rates set below market-clearing rates, the government was also in a position to influence commercial banks’ allocation of credit to industry.
Changing economic conditions, however, began posing challenges to regulatory controls toward the end of the 1970s. Rapid increases in government deficits and resistance from the financial community to the low fixed interest rates at which government debt was issued led to a gradual freeing of interest rates. Shifts in profitability among different kinds of banks led to lower barriers among the various segments of banking. Since the mid-1970s controls over foreign exchange have also been extensively eased.
But the pace of deregulation has been halting, and results have been mixed. Encouraged by the Ministry of Finance, the large commercial banks moved into real estate in the 1980s but quickly engaged in imprudent lending. Their indiscretion helped feed the real estate and stock market speculation in the late 1980s, and the collapse of those speculative bubbles has left the banking sector saddled with enormous amounts of non performing loans and badly tarnished reputations. At the end of the third quarter of 1997, non performing loans officially totaled 28 trillion yen or some $230 billion. Private estimates run as high as $700 billion (by way of comparison, all commercial and industrial bank loans made in the United States total just over $800 billion).
Japanese financial institutions also used their new freedom to expand rapidly in world markets in the 1980s, only to discover that their highly protected history left them poorly equipped to compete. Able to gain market share through aggressive pricing of loans and other financial services, but unable to evaluate risk, they have been retreating from many of those markets in the 1990s. In the reverse direction, foreign financial institutions rushed into liberalized Japanese markets during the 1980s, only to be hamstrung by remaining regulations that kept transactions costs high and deprived them of many competitive advantages in the market.
The New Deregulation Agenda
Japanese government officials, distrustful of letting markets allocate credit in the economy, had been quite satisfied with the tightly controlled financial system of the 1950s through the 1970s. But the gradual deregulation of the past 20 years has changed that system irreversibly, and the insistence of some officials that further deregulation is necessary to yield a stable and efficient new regime led Prime Minister Hashimoto to promote the Big Bang reforms, which promise benefits both for Japanese consumers (individuals and businesses) and for foreign firms seeking business in Japan.
For example, further deregulation of foreign exchange rules – especially ending the monopoly of certain commercial banks over the foreign exchange business and liberalizing limits on individual investment overseas – will enable Japanese depositors who now earn as little as one-tenth of 1 percent interest on their yen accounts at Japanese banks to get much higher returns in foreign currencies (provided they are willing to accept the risk of depreciation of those currencies against the yen). The new rules should also widen opportunities for non-Japanese banks to compete for Japanese funds.
Securities market reforms – including decontrolling brokerage commissions, easing rules concerning trading shares off-exchange and over-the-counter, easing rules on trading financial derivatives, and dropping the securities transactions tax – should spur competition, thus benefiting Japanese securities investors while broadening opportunities for firms (foreign and domestic) outside the “big four” Japanese securities houses.
Insurance sector deregulation – permitting price competition, greater flexibility in product design, and removal of barriers between life and nonlife insurance companies – should bring similar benefits to insurance consumers and non-Japanese insurers seeking to expand business in the Japanese market.
By legalizing financial holding companies capable of owning banks, insurers, and securities firms (with some restrictions on size and scope), Japan will throw off the yoke of restrictions on cross-industry competition imposed by the United States after World War II. Subject to an important caveat spelled out below, this reform should give Japanese consumers the same benefits of “one-stop” financial shopping that European “universal banks” have provided their customers (and that some American financial institutions are seeking to emulate, pending further modernization of U.S. financial laws).
In principle, Japan will legalize “asset-backed securities,” such as the mortgage-backed securities that have revolutionized home finance and helped make housing more affordable in the United States.
By allowing Japanese pension funds greater investment freedom – specifically, broader authority to purchase equities, domestic and foreign – the Big Bang will help ease the pressure on Japanese corporations to fund their pension plans with current earnings.
Potentially most important of all, Japan will replace its cumbersome and deliberately restrictive policy of licensing all new financial institutions. Instead, financial regulators will simply attest to the financial soundness and noncriminal backgrounds of those seeking to enter the financial business (much as U.S. regulators now do). Together with the planned decontrol of insurance and securities commissions, this reform should make it easier for foreign and domestic entrants to compete in the Japanese marketplace.
The list of potential reforms is considerably longer, but many of the items proposed are either minor or still quite vague. Deregulation of foreign exchange transactions, removal of the bank holding company ban, and decontrol of brokerage commissions all will begin in 1998. Other moves should follow over the next three years.
Big Bang: Some Caveats
For all its merits, Big Bang will still leave the Japanese financial system short of complete reform in important ways.
First, it is unclear whether Japanese financial institutions will shift their internal practices to meet the new challenges. Japanese corporations, both financial and nonfinancial, have strongly favored rotating individuals broadly through the organization rather than encouraging specialization. But complex financial markets require specialized expertise. Similarly, understanding the complexities of financial markets requires strong mathematical skills. But, as in Japan’s economy generally, decisions in Japanese financial institutions are based to a large extent on personal relationships with clients (and internally with one’s colleagues) rather than on careful quantitative analysis. These entrenched practices – at the core of what many Japanese believe is the essence of their brand of capitalism – are not easy to change. But no one is even talking about the need for such change.
Second, if markets are to operate on the basis of dispassionate risk analysis rather than personal relationships, markets and financial institutions need access to accurate and relevant information. Corporate annual reports in Japan convey relatively little that is useful, and official financial filings are little better. As with personnel practices, this problem is deeply imbedded in the fabric of Japanese society. Information does not flow as freely in Japan as in the United States, and it tends to run in channels characterized by close personal or corporate ties. Under the Big Bang, corporations are supposed to change their accounting practices from registering assets at purchase cost to current market value, but this is only one of many changes needed to provide markets with adequate information to evaluate risk and potential returns.
Third, the failure of the reform package to envision a marked reduction in “stable stockholding patterns” is yet another obstacle to change in non financial corporate governance and behavior. The bulk of corporate equity in Japan continues to be held by other corporations (both financial and non financial) on a long-term basis to cement relationships or protect one another from hostile takeovers. As a result, corporate behavior does not respond to fluctuations in share prices, and the stock market plays little real role. Optimists believe that banks, permitted to own up to 5 percent of the equity of other corporations, will be forced to sell off these large holdings of shares if deregulation implies a more competitive market (creating an environment in which they cannot afford to hold shares for essentially uneconomic reasons). But it is far more likely that those shares, if actually sold, would be placed with other friendly corporations, with little change in the overall pattern. Thus the stock market will remain relegated to trading a minority of issued shares, with little real impact on corporate behavior or ownership control.
Fourth, legalizing holding companies may not be as revolutionary as some observers expect. While the change will allow financial institutions to enter fields of business previously denied them, the record of the banks in operating subsidiaries, especially the jusen real estate lending organizations that were at the center of the bad debt fiasco, is not encouraging. Optimists also believe that holding companies will give nonfinancial firms a way to acquire or expel business divisions in response to pressures to restructure themselves more efficiently. Without market discipline or an active merger and acquisition market, Japanese corporations have had a tendency to maintain poorly performing divisions. But underlying the lack of acquisitions and divestitures in Japan have been strong social constraints on personnel practices. A firm that acquires another has virtually no ability to downsize the workforce or greatly alter upper management, and there is no sign that this problem is changing. The new holding company format is therefore unlikely to cause a burst of effective corporate restructuring.
Fifth, all the talk about deregulation remains at odds with Japanese government behavior at the bargaining table. Insurance is being touted as a major part of the financial Big Bang, but the reforms came only after three years of often bitter negotiations between Japan and the United States. Without heavy American pressure, the internally generated Big Bang would have fallen far short on allowing price competition, product innovation, and new marketing techniques. Other areas of domestically generated deregulation are thus likely to be disappointing to foreign observers when the final rules are settled and implemented. For example, although the rhetoric of Big Bang has emphasized total decontrol of foreign exchange transactions, the Ministry of Finance already has announced (even before the new rules go into effect) new reporting requirements, designed to inhibit tax evasion, for anyone moving more than 2 million yen (about $18,000) into or out of the country. These rules could have a chilling effect on transactions. If they do not, and if massive out flows of funds go from Japanese to foreign banks, the ministry would be likely to impose stiffer restrictions to slow the exodus so as not to precipitate a run on Japanese institutions.
Finally, to be fully effective, financial deregulation requires a population willing to take advantage of newly available financial instruments. But the Japanese public remains distinctively risk averse in its investment decisions, keeping a high share of its savings in the form of bank accounts and insurance policies. It is not at all clear that they will jump at the chance to broaden their savings portfolios to include asset-backed securities, foreign mutual funds, derivatives, foreign bank accounts, and other investment opportunities. In the absence of an eager household sector, financial deregulation could leave the Japanese financial system under the continued domination of banks, which may end up as the primary holders of the new financial instruments. This was the story of corporate bond deregulation in the 1980s; as the bond market was gradually decontrolled and allowed to expand, the primary purchasers of corporate bonds were banks. In the end, little changed in the real flow of funds or in the way institutions handled information and made lending decisions.
Unfinished Business: The Banking Mess
Sometimes the most important element of any government policy initiative is what is not included. For the Big Bang, the missing element is a clear policy for shoring up the nation’s banks, whose real economic capital (as distinguished from the officially reported capital figures) has been severely depleted by nonperforming loans. An honest accounting of the Japanese banking situation would probably reveal that numerous insolvent banks remain in business, while many others have capital well below international standards. Failure to confront this huge problem undermines the Big Bang, since altering a system filled with very weak institutions could be too traumatic for officials and politicians to push with any vigor.
To be sure, it took U.S. policymakers years to own up to the mess in the U.S. financial system during the 1980s savings and loan crisis – during which time the problems only grew worse. But when regulators did take action, beginning in the late 1980s, they did so forthrightly, shutting down insolvent banks and thrifts and paying off their depositors or, in other cases, providing some government funds to induce healthy institutions to take over the insolvent ones. Meanwhile, regulators forced weakly capitalized banks either to shrink or to obtain new capital. The process was painful and arguably delayed the recovery from the 1990-91 recession, but after it was over, the United States was left with one of the world’s strongest banking systems.
Japan faces several hurdles to adopting the U.S. model to resolve its financial institution mess. On the political front, elected Japanese leaders and officials in the Ministry of Finance fear popular opposition to using public funds even to put insolvent institutions out of their misery. The bold action in November protecting deposits at Hokkaido Takushoku Bank, one of Japan s largest, is an encouraging sign. The critical question now is whether the Japanese authorities will mount a larger bank cleanup program. A key impediment to doing so is that relatively few healthy Japanese banks are capable of taking over the many other weaker ones. In principle, this drawback could be overcome if Japan were to court foreign banks and financial institutions to bid for weak and insolvent Japanese banks. But foreign interest is limited by opaque Japanese accounting practices. With Japan’s real estate market virtually frozen – by inefficient zoning rules, heavy transactions taxes combined with very light property taxation, inadequate ability to remove tenants, and other problems – and with few transactions taking place, it is hard for anyone, foreign or domestic, to know the true value of the real estate collateral that underpins most Japanese nonperforming loans.
Although no single change is likely, by itself, to lead to a cleanup of the Japanese banking situation, the government has no other choice except eventually to use public funds to solve the problem. As long as the banks remain weak, the overall Japanese economy will struggle to mount a healthy recovery. The Big Bang reforms desperately need a healthy economy to succeed.
Japanese policymakers can learn at least one negative lesson from the United States. In the 1980s, the United States eased asset investment restrictions for thrift institutions, most of which were insolvent at the time yet continued to operate because of deposit insurance. With incentives to gamble for resurrection, many thrifts abused the wider investment authority they were given and wasted billions in busted real estate deals. Facing a similar situation now with its banks, therefore, Japanese policymakers would be prudent to limit the ability of weak banks to affiliate with or be owned by nonbanking enterprises – which could be used to run excessive risks in the hope that the payoffs from the gambles would be used to help their weak banking sisters. To prevent such an outcome, the authorities should insist that only well capitalized banks – measured by honest accounting rules – be permitted to take advantage of the broader powers allowed under the new financial holding company legislation.
Perhaps the Start of Something Big?
Japan’s Big Bang is certainly bigger than previous reform efforts and thus should promise some significant changes in the country’s financial system. Even with the caveats expressed above, the proposed changes are a positive development. But more sweeping reform remains to be implemented, while sizeable problems in the banking system continue to fester. Incompleteness of the current round of reforms will leave many inefficient or undesirable practices in place, and the banking mess may sap the strength of reform. Look for an even “Bigger Bang” sometime down the road.
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