Capital Idea: Open Japan’s Banking Industry

Prime Minister Junichiro Koizumi’s reaffirmed mandate after last month’s victory in the Upper House election has given hope to those concerned about Japan’s economic future that the ruling Liberal Democratic Party will finally do what it takes to cure the nation’s ailing banking system. The problem is staggering, and can be lived with no longer. According to one of Japan’s most respected economists, Mitsuhiro Fukao of Keio University, Japan’s banks are riddled with more than $600 billion in troubled loans.

If only half this amount is eventually collected—a not unreasonable assumption—then Japan’s banks in the aggregate face losses of more than $300 billion, enough to wipe out their entire current-capital and loan-loss provisions. This amount would be proportionately more than four times the share of gross domestic product that the United States spent cleaning up its savings and loan debacle of the 1980s.

Past Japanese governments have kept weak banks open hoping that an economic recovery would eventually allow the banks to recover their distressed loans. With virtually no real shareholder money at risk since the mid-1990s, and implicit government guarantees of their liabilities, bank managers have had every incentive to rollover outstanding loans to already troubled borrowers rather than write off the losses. Until the bad loans are resolved, and the insolvent institutions are recapitalized with sufficient real capital (instead of a government license to remain open), they will continue to gamble for resurrection and add to the stock of bad loans.

So the fix for Japan’s banking crisis clearly has two parts: Bad debt (and the associated real estate as collateral) must be removed from the banks and handed over to the government for resolution. To its credit, the Koizumi government realizes this and has recently proposed moving all nonperforming loans out of the banking system.

But the second part is recapitalization, and the government has not explicitly addressed this task. Where will the vast sums of money needed be found? Not from the Japanese banking system itself, which has been unprofitable for years and has no more capital left to give.

The scale of capital injection that would be required from the government would mean formal nationalization of the banking system. As a short-run waystation on the road to reprivatization, and to avoid a crisis during the transition, such a step might make sense (as it did for Scandinavian governments in the 1980s and 1990s when their banking systems went bust). But Japan has suffered from the de facto nationalization of its banking system for a decade, a set-up which only institutionalized the perverse lending patterns. As recently as March 1998, when the government got de jure ownership stakes in the form of preferred shares in the 11 biggest banks, it failed even then to impose fiscal discipline to bring them into line. Coming in the wake of the 1997 collapse of Yamaichi Securities, that was a bailout that cost the Japanese taxpayer more than $14.7 billion.

The time for privatization clearly is now—with the infusion of competitive discipline it will bring. But what private sector sources of capital remain?

The Japanese corporate sector, with healthy companies like Toyota, Honda and Sony, could be one source. Some of these companies are already starting financial-service subsidiaries. But as always, the issue of nonfinancial firm ownership is whether bank managers can prevent the banks from steering funds on favored terms to the corporate owners or their designees, such as suppliers. In a bank-dependent economy like Japan’s, with limited securities markets and disclosure, it would be almost impossible for bank supervisors to prevent favored lending if industrial firms owned a large part of the banking sector. And no one wants to revive images and practices of the pre-war zaibatsu system.

That leaves one other source of capital: foreign financial institutions, which can bring to the Japanese economy not only money, but also the lending and risk-management practices that have made them successful in world markets. The experience of other countries (like Australia and Argentina) receiving foreign-direct investment into their financial sector indicates that transfer of technology and best corporate governance practices does occur in banking, as in most other industries that have attracted FDI. This process has already begun with the Ripplewood Holdings purchase of the once-nationalized Long-Term Credit Bank from the Japanese government, as well as the expansion of foreign merger and acquisition activity throughout Japanese financial markets.

But some resistance to this kind of inward FDI has already taken place in Japan; the decision that, following the LTCB takeover, the nationalized Nippon Credit Bank, which went bankrupt under a mountain of bad loans, had to be sold to a domestic buyer was the most notable example.

So the Koizumi government should think of face-saving ways to engineer a rejuvenation using FDI. Government leaders can and should present this alternative to the Japanese public as the only fiscally sound way to finally resolve the banking problem.

In effect, they should tell the public that the Japanese banking industry requires rejuvenation through inward FDI in much the same way that the American automobile industry did in the 1970s and 1980s. Only the infusion of Japanese and other foreign capital into the U.S. domestic auto sector—through both creation of competing plants and takeovers and joint ventures—resulted in the needed new investments. As a result, American auto factories adopted the production and Total Quality Management practices that made them competitive again. Now the shoe is on the other foot, and Japanese banks need American and other foreign capital to regain competitiveness.

This will be a bitter pill, difficult to swallow for many Japanese, who place a high value on the independence of their nation’s post-war development, and can remember when they considered (albeit incorrectly) the banking system to be the world’s most efficient. But at some point national pride must give way to practical necessity, as it did in the equally proud U.S. auto industry.

There is no sustained solution to Japan’s economic problems without bank reform, no effective bank reform without recapitalization, and no viable recapitalization without foreign capital. The sooner Japanese leaders and the Japanese public come to accept this logical conclusion, the better off Japan and the rest of the world economy will be.