Japan: Banking system or welfare state?

"In Japan, I feel the fashion is to bash bankers. This is not a sound move in a modern society. It is a little bit hysterical," ponders Shin Nakahara, the corporate planning boss of Bank of Tokyo-Mitsubishi.

Contemplating the sheer scale of the bank rescue ahead of them - estimated needs $500 billion - Japanese bankers might feel like turning round and bashing the Basle Committee on Banking Supervision.

In Basle 10 years ago the British and Americans capitulated to the Japanese ministry of finance (MoF) on the issue of tier-two capital. The concession allowed banks to count, as tier-two capital reserves, up to 45% of their hidden assets - that is to say, unrealized gains on their equity portfolios.

This defeated the whole effort of the Basle Committee to harmonize banks' capital adequacy ratios (BIS ratios) in the Group of 10 industrial countries. The British and American regulators had gone to Basle intent on forcing Japanese banks to boost their equity capital from 4% of all assets to 8%. The concession won by the MoF meant a tier-one ratio of 4% could be balanced by unrealized stock market gains of 4%. Japanese banks could say their capital adequacy matched that of their western counterparts even though their outstanding shareholders equity had not changed at all.

This arguably is the root of Japan's instability today. When times are good - the currency strong and equity markets bullish - the value of unrealized gains increases, the BIS ratio increases and the banks have scope to lend more. In an asset price bubble, lending increases even faster. When times are hard the process quickly reverses, forcing banks to cut lending at a time when companies most need working capital.

In 1992 the hidden equity gains of the top 19 Japanese banks stood at ¥17 trillion. Today the weak stock market has wiped out the gains. At the banks' year end in March 1998, with the Nikkei stock index hovering around 16,500, hidden equity reserves were reduced to ¥1.8 trillion. Moodys' Investors Service reckons that all aggregate reserves of the banks are wiped out if the Nikkei goes below 16,000. On September 9 it was 14,756.

It gets worse. Japan's banks have enormous dollar-denominated loan books. So when the yen weakens against the dollar, their risk assets increase in yen terms. Unless more capital is found to offset this rise, their BIS ratio falls. James Fiorillo, a bank analyst at ING Barings estimates that for every ¥10 drop against the dollar, the BIS ratio is cut by 50 basis points.

Bank of Tokyo-Mitsubishi calculated its BIS ratio at year end in March 1998 using a rate of ¥134 to the dollar. Its BIS ratio was 8.53%. With the yen at ¥144, Fiorillo's rule of thumb suggests it's now fallen to 8.03%.

The banks are caught in a downward spiral. As confidence wanes, so too does the stock market and the currency. As the economy worsens, so too do bankruptcies (up 238% in June) and so too do the banks' profit-and-loss as they absorb credit losses. Their tier-one capital takes a hit when the bank moves from profit into loss. While they can play any number of accounting tricks with tier two - such as revaluing land holdings, which is the MoF's latest favourite - the tier one ratio is hard to fudge. Shareholders' equity is shareholders' equity. And tier two capital cannot be bigger than tier one. So, in the absence of fresh equity, the only way to keep the BIS ratio above 8% is to reduce assets. This is the cause of a deflationary credit crunch every bit as severe as the earlier asset-price bubble.

"I feel some responsibility for the banks' current difficulties," says one of the Japanese bureaucrats who negotiated the deal in Basle in 1988. "I don't think the tier two concession was such a healthy thing for the banks after all."

However, the banks can't simply blame these officials. Basle capital standards only set a regulatory minimum. Banks are responsible for holding enough capital in the right form to ensure their survival. And Japanese banks have applied different standards to their subsidiaries elsewhere in the world. Japan's biggest bank, Bank of Tokyo-Mitsubishi, has a tier-one ratio of 4.27%, but its wholly-owned subsidiary Union Bank of California - US regulated - has a tier-one ratio of 8.96%, and an overall BIS ratio of 11.05%. Tokyo-Mitsubishi, or rather its two components, might have looked more like their subsidiary if they had been faced with a stark choice in 1988 - increase tier-one capital or reduce loans.

Now, deeper structural problems in Japan are combining with the effects of inadequate bank capitalization to threaten the entire system. As Heizo Takanaka, professor of Keio University says, Japan has a two-tier economy. "The dual nature of the economy pits industries with high productivity - which can compete in international markets even with the yen as high as 100 to the dollar - against low productivity industries that are operating on a 200-yen level [they could only compete internationally if the yen fell to that level], surrounded by protective regulations. The 200-yen industries survive by clinging to the 100-yen industries."

Who needs return on equity?

This has implications for the country's banking system. For the 200-yen industries to survive, the banks must lend to them at roughly the same rate as they lend to the 100-yen industries. This goes a long way towards explaining the banks' dire performance.

Around 85% of Japanese banks' earnings derive from lending; 50% of their risk-weighted assets are lent to big corporates at about a 50bp spread; the net interest margin on the overall loan book is 1.3%; the average return on equity (ROE) is 2.1%. Compare this with US banks which earn less than 40% from the credit spread business, have a margin of 4.3% and an ROE of 20.7%.

Since 1992 Japan's banks have incurred ¥40 trillion of bad debts. Nor is it over yet. Yukiko Ohara, bank analyst with Morgan Stanley, reckons the top 19 need to provide a further ¥20 trillion against bad debt. If her estimate is correct, the net asset value of the top 19 is close to zero. That excludes the impact of the present recession and bad debts it is creating. Japanese banks spend too much of their resources lending to borrowers who should be using bond markets. Nor have they won much higher-margin business on the back of these loans.