The Clogged Arteries of a Troubled Economy

For weeks, the world has been waiting for the Japanese government to agree on an aggressive plan to clean up the country’s worsening banking mess. The need could not be more urgent. More so than in the United States, banks act as the financial circulatory system of the Japanese economy, which continues to ail. The arteries of that system are so clogged with bad loans—more than $1 trillion, by some estimates—that even tax cuts and a looser monetary policy cannot be fully effective until the blockages are removed. Otherwise, Japanese consumers will not give their banks more money to lend, and the banks will lack the financial capability to extend new loans to credit-worthy borrowers.

The first signs of positive movement came last week, when the Japanese government let Japan Leasing, an $18-billion company, go bankrupt without taxpayer assistance. In addition, the government has decided to handle Japan Leasing’s insolvent affiliate, the Long-Term Credit Bank, like the United States handled its hundreds of failed thrifts and banks earlier this decade. Long-Term Credit will be taken over by the government, its depositors protected, while its bad assets will be handed off to the Japanese equivalent of our Resolution Trust Corp. and sold off. Sale of the cleaned-up bank to the highest bidder will follow.

The question now is whether Japanese authorities will move with the same dispatch to attack the many other insolvent banks. Two huge hurdles stand in the way that make Japan’s banking problem far worse (apart from its size) than the one the U.S. faced. In calling for Japan to “do something quick” about its banking mess, U.S. officials must be sensitive to these roadblocks.

First, Japanese consumers, already big savers, tend to save even more as they learn companies are going bankrupt, which occurs with increasing frequency as banks tighten credit. While saving is good for each individual or family, if too much is saved throughout the country, the economy will sink further. Any bank-rescue plan that forces more marginal borrowers into bankruptcy is likely, therefore, only to worsen Japan’s economic slump.

Second, if the assets of Japanese banks were truly reckoned at their market values, it is conceivable that much, if not most, of the nation’s banking system would be underwater. Furthermore, of those banks that are solvent, few if any have the wherewithal to buy the insolvent banks, even after they are stripped of bad loans. This means the only banks that may be healthy enough to buy the cleaned-up Japanese banks would be foreign institutions. A few such purchases would be politically palatable, but is Japan prepared to hand over most of its banking system to foreigners, especially at what may be fire-sale prices?

The “bridge bank” rescue plan proposed by the ruling Liberal Democratic Party over the summer was designed to get around these hurdles. The bridge banks would warehouse the husks of the insolvent institutions for up to five years. The LDP didn’t say explicitly, but its purpose behind the delay in selling the bridge banks was obviously to buy time for the rest of Japan’s banks to recover, so they would eventually be healthy enough to buy. Meanwhile, to address the bankruptcy problem, the original plan encouraged bridge banks to continue lending to marginal borrowers.

The LDP plan was a reasonable first draft, but it had obvious flaws. Leaving the bridge banks in business for as long as five years without profit-motivated individuals running them would make it more difficult for their privately run competitors to survive. Furthermore, giving more money to marginal borrowers would drive them deeper into debt and deprive more deserving borrowers.

So, what can Japan do? First, it should set up bridge banks as rapidly as possible, but send all their nonperforming loans, including those to marginal borrowers, to a Japanese version of the Reconstruction Trust Corp. That institution, in turn, should forgive some portion of the loans in return for equity in the borrowers, who might also be given options to buy the equity back within some period of time at a reasonable premium.

It will be said that giving this much power to a government agency will lead to sweetheart deals with politically favored borrowers, such as construction companies, that are strong LDP supporters. This is a danger, but one that can be addressed by announcing clear and objective criteria for the equity-for-debt swaps.

Why not let the bridge banks cut these deals? One impediment is Japanese banking law, which prohibits banks from owning more than 5% of any company’s shares. This restriction would not apply to the government-run trust. More important, arranging these swaps will take some time. If the bridge banks were given the job, this would delay their cleanup and sale to healthy buyers.

This plan would avoid a rash of bankruptcies, while the government would get some portion of the upside as firms recovered. Equally important, bridge banks could be cleaned out in short order and readied for sale.

To whom? One answer is for the government to accept that the highest bidders may be foreign financial firms. But there is another option: Encourage cash-rich Japanese commercial firms, such as giant automobile or electronics firms, to enter the bidding for the cleaned-up banks. It will be said, of course, that allowing the resurrection of interlocking Japanese business conglomerates, known as zaibatsu, would lead to excessive concentration of economic power. That is a problem, but one that could be addressed by strict limitations on bank lending to owners similar to those we enforce for our banks and their financial affiliates and owners.

Japan now appears intent on a third option: having the government inject taxpayer funds into weak banks in return for preferred stock. This seems sensible, but there are grave risks involved. Because an honest accounting would reveal that most surviving Japanese banks need such public funds, the government would be setting up a major conflict of interest: attempting to regulate the many banks in which it will also be a major owner. Since “administrative guidance” of banks by the Finance Ministry helped land them in their current mess, government ownership hardly seems the answer.

In short, there is a way out for Japan and it need not involve the wave of bankruptcies the country’s authorities rightly fear, nor the radical approach of a government takeover of banking.