Japan's Financial Crisis Requires a Comprehensive Solution Research by Anil Kashyap
New research estimates that taxpayer liability for the Japanese
financial crisis will total at least 24 percent of Japan's GDP.
In the past ten years, Japan has been hindered by an economic
slump of dramatic proportions-including a stock market collapse,
a sustained decline in real estate prices, and eventually the
first case of deflation since the 1930s. After averaging more
than 3.8 percent between 1974 and 1991, economic growth in Japan
has dropped to 1.1 percent since 1991. While much attention
has been given to the problems of Japanese commercial banks
and their role in these developments, there are equally important
problems in the insurance sector and government-sponsored financial
institutions, such as the Housing Loan Corporation.
In a new article, "Sorting Out Japan's Financial Crisis,"
Anil Kashyap, a professor at the University of Chicago Graduate
School of Business, suggests that Japan's banks, insurance companies,
and government financial agencies are so closely connected that
any reform plan will have to tackle all three sectors concurrently.
However, each sector suffers from different problems and requires
different solutions, all of which impede the resolution of the
crisis and increase the cost.
While many of the ingredients for a successful resolution are
clear, the financial crisis is sufficiently broad and deep that
the necessary institutional changes cannot be initiated or implemented
"Banks in Japan just aren't very profitable," says
Kashyap. "The banks are going to have to shrink and reinvent
themselves, but there is tremendous resistance to change."
The difference between the amount of deposits and the value
of the assets of the financial institutions is conservatively
estimated to be 120 trillion yen. This means that fully paying
back the depositors will require a transfer from the government,
either financed through higher taxes or reduced spending on
other programs. But one way or another, the Japanese taxpayers
will end up bearing the costs.
To put this figure in perspective, one can convert it into
dollars, and using an exchange of 120 yen per dollar implies
an infusion of $1 trillion. Because exchange rates are so volatile,
economists often express this figure as a proportion of GDP,
which for the last few years in Japan has been about 500 trillion
yen. This suggests a transfer of roughly 24 percent of GDP,
eight times the size of the U.S. bailout of savings and loans.
(All subsequent figures will be stated in yen, but can be converted
using either of these two methods.)
"We are fighting over President Bush's tax cut and whether
it should be made permanent or repealed," says Kashyap.
"But the amounts involved are a spit in the ocean compared
to what we're talking about in Japan."
A Financial System in Disarray
The collapse of the Japanese stock market in the early 1990s
may receive most of the blame for the current financial crisis,
but Kashyap points out that the losses are too large and persistent
to be the result of the asset price collapse alone. Banking
sector problems also reflect the weakened condition of borrowers,
and underlying corporate sector issues must be addressed.
Until the late 1990s, Japanese banks offset their losses by
recognizing capital gains on long-held stocks and land. There
is currently little left to be collected from these sources.
Since 1992, banks have recorded losses of approximately 83 trillion
yen, including 32 trillion yen in outright write-offs. Losses
are expected to continue for the foreseeable future.
This lack of profitability represents an important barrier
to streamlining the Japanese banking system. In basic terms,
the problem is that the banks consistently fail to generate
enough revenue on their loans and other assets to repay their
depositors and cover their operating costs. But at a deeper
level, Japanese banks have very few product niches where they
can successfully compete against global competitors. While Japanese
banks are among the largest in the world in terms of assets,
they are not world leaders for most product lines.
"For most complicated banking products, you wouldn't trust
the Japanese banks," says Kashyap.
These shortcomings are aggravated by the fact that Japanese
banks often have to compete domestically against subsidized
government firms. Furthermore, bank employees' salaries are
too high given their competencies, and banks did not invest
enough in technology during the late 1990s. As a result, Japanese
banks lag far behind the technological efficiency of many of
their global competitors.
As the losses have piled up, the banks have seen their capital
levels dwindle; they are now close to the regulatory minimums.
This has led Japanese banks to roll over loans rather than pulling
the plug on bankrupt firms, because pulling the plug would further
deplete their capital. These bailouts and rollovers keep deadbeat
borrowers in business and distort competition. Thus, fewer new
firms are created and existing profitable firms are less likely
to expand. The combination of insolvent banks lending to insolvent
firms is depressing the economy.
"In normal times and normal economies, you see a lot of
loan renewals," says Kashyap. "But here it's being
used as a mechanism to avoid recognizing bad news and losses."
The life insurance sector is the second largest part of the
Japanese financial system. Kashyap estimates that insurance
companies own 10 percent of the equity of each major Japanese
bank. Japanese banks hold a significant amount of insurance
company debt as well, usually in the form of subordinated loans
or surplus notes. As a result of this "double-gearing,"
the amount of actual capital in each sector is overstated. The
total amount of money needed to buy two firms linked in this
way is less than the apparent value of each company, since a
buyer purchasing one already gains a stake in the second. More
importantly, any losses in one firm will spill over to the other.
Since many Japanese life insurance companies are in poor financial
condition, this hypothetical concern is of considerable practical
Life insurance companies have many of the same problems as
commercial banks: bad loans, exposure to changes in the stock
market, and competition from government-sponsored institutions.
But Kashyap suggests the bigger problem is that insurers promised
to pay their policyholders more than they have been able to
earn. This has caused a number of life insurers to go bankrupt,
and more are likely to fail in the next few years. In the meantime,
the double-gearing should be reduced so that when these troubles
surface they do not lead to further banking problems.
The Need to Compete with Subsidies
Government financial institutions provide an array of services
in Japan, from life insurance to financing highway development.
Many of these agencies are losing money and will require taxpayer
buyout, which constrains the money available for insurance and
Japanese banks and life insurance companies face stiff competition
from government financial institutions. The postal system in
Japan offers checking and savings accounts, and sells life insurance.
Besides offering the convenience of having forty times the number
of offices as the largest banking group, the postal savings
program charges no maintenance fees and comes with the added
benefit of a full government guarantee on deposits.
The postal life insurance program sells about one-third of
the life insurance in Japan. Premiums paid into postal insurance
accounts are often recycled to finance other (money-losing)
The government-subsidized Housing Loan Corporation (HLC) is
another institution that compromises the commercial banking
system's ability to make money through mortgage lending. The
HLC passes its subsidies as savings to consumers, and as a result
the HLC originates approximately 40 percent of all home mortgages.
These types of government-sponsored financial institutions
will need to be reined in if Japanese banks are to regain profitability-a
fact widely recognized outside Japan. However, these programs
are popular with the public, who remain unconvinced that such
programs are contributing to the banking troubles.
In 2002, Prime Minister Junichiro Koizumi appointed Heizo Takenaka
as Japan's financial services minister. Takenaka subsequently
formed the Financial Sector Emergency Response Project Team
to study the bad debt problem. Takenaka's task force suggested
the following: reducing the length of time that could be used
to claim tax credit as part of banks' capital; tightening loan
assessment standards; and forcing banks to increase provisions
for losses. However, many politicians have fought the Koizumi
administration's reform efforts.
"Politicians know what needs to be done," says Kashyap.
"It's just a question of imposing the pain."
A major public policy issue is whether government agencies
should continue to compete with private sector firms. The problems
marring these government institutions include inadequate recognition
of losses (sometimes reporting past losses on agency books as
assets), and overvaluing physical assets.
The sheer size of the losses makes politicians hesitant to acknowledge
them. Kashyap recommends building public recognition of the
losses, and suggests the following intermediate steps:
1. Reduce the flow of government money to insolvent borrowers.
2. Restructure the operation of unprofitable government-sponsored
3. Level the playing field between government agencies and the
When Will the Crisis End?
Kashyap warns that banking system problems will persist until
problems with the insurance sector and government-sponsored
financial institutions are addressed. The government will have
to be willing to force the restructuring needed to create a
profitable banking sector. These measures will inevitably lead
to business closures and job losses.
The reluctance to address the underlying insolvency of the
corporate sector partly accounts for the current gridlock. However,
Kashyap sees an end to the crisis within the next decade.
"Eventually when this crisis is resolved, the yen will
likely weaken," says Kashyap. "I think ten years from
now, Japan's financial system will look a lot more like ours."
Anil Kashyap is professor of economics at the University
of Chicago Graduate School of Business.