Solving Japan’s bad-debt crisis is the key to reviving its moribund economy.
By Charles Smith
November 2001
Institutional Investor Magazine
Solving Japan’s bad-debt crisis is the key to reviving its moribund economy. So why won’t the Koizumi government get serious?
Last December Japan’s biggest banks performed a routine assessment of their loans to Mycal Corp., the country’s fourth-largest retailer. The supermarket and general merchandise chain, whose slogan is “Young Mind and Casual Amenity Life,” had been struggling during the country’s decade-long downturn. Sales had slid 6 percent over the past three years, and debt kept piling up because of the company’s brash diversification drive into sports clubs, fast-food restaurants and credit cards. Still, all but three of the banks ranked Mycal’s debts as seijo, or normal. Only one classified them as yo kanri saki, or special watch, requiring that a 15 percent provision be set aside against defaults.
Over the next several months, Mycal’s lead creditor, Dai-Ichi Kangyo Bank, pumped ¥14.4 billion ($117 million) of fresh loans into Mycal to prop up the increasingly troubled company. This past June Japanese rating agency Rating and Investment Information sharply downgraded Mycal’s credit status, citing the company’s burdensome bond payments. Then on September 14 Mycal declared bankruptcy; its debts came to almost ¥1.7 trillion.
Yet on the news of the Mycal collapse, the Nikkei 225 stock average soared 428 points. In the surreal world of Japanese finance, this reflected a certain logic: Investors concluded that in removing Mycal from the respirator, DKB and other banks were signaling that they were prepared at long last to get tough with other debt-ridden companies in overextended industries like retailing and construction.
At the same time, Japan’s top financial regulator, the Financial Services Agency, goaded by the banks’ stubborn denial in refusing to acknowledge Mycal’s longstanding problems, stepped up bank inspections. Minister for Economic and Fiscal Policy Heizo Takenaka, the point man on economic reform for Prime Minister Junichiro Koizumi, proclaimed that the FSA would “greatly tighten” its assessment of bank assets. The agency will now conduct emergency inspections of any big bank whose credit rating is downgraded or whose stock price tumbles, as well as perform regular inspections every year rather than every other year (see box). In addition, the FSA is requiring banks to make further provision for troubled borrowers and encouraging them to offload bad loans to a government-sponsored debt-cleanup agency.
But the lack of urgency underlying the latest measures, announced on September 21, indicates that the government is still only gradually coming to grips with the full dimensions of the quickly worsening bad-debt crisis. “One point that’s become abundantly clear in the past two months is that Koizumi doesn’t understand the nonperforming-loan problem and doesn’t even want to,” says a former senior official of the Bank of Japan who is now a consultant for an international accounting group. “He’s known for warning members of the cabinet that they shouldn’t study issues too hard; otherwise, they might get entrapped by bureaucrats.” Adds a financial counselor at a Western embassy who’s had considerable experience of his own inspecting banks: “What we saw at the end of September wasn’t great shakes. It was more a case of the FSA doing a bit more of what they were doing already.”
Most alarming of all, Tokyo has yet to commit any more public funds to bolstering major banks that can’t afford to cope with nonperforming loans on their own, thus preventing them from dealing with bad debts that should have been disposed of years ago. This suggests a frightening lack of touch with reality, as Japan’s economy descends into a deflationary spiral that threatens to create a mass of new nonperforming loans. Recession also makes it harder than ever for banks to write off existing bad loans out of profits. The September 11 attacks, in pushing the world closer to or into recession, threaten to make matters much worse. In the extreme case, the consequence could be financial turmoil at least as bad as the 1998 Asian crisis - but this time with Japan at the vortex.
“The Japanese economy depends on individual consumption, and individuals won’t spend while they feel there’s something seriously wrong with the banking system,” points out the former vice minister of international affairs at the Ministry of Finance, Toyoo Gyohten. “The best message we could send to the outside world is that we’re getting on top of the nonperforming-loan problem.”
Nevertheless, it’s not even clear how extensive that problem is, though it is indisputably enormous. The FSA estimates that nonperforming loans held by banks and other deposit-taking institutions (such as cooperatives and agricultural credit organizations) total about ¥43 trillion, based on what the agency says are objective international accounting standards. This would be equivalent to some 4 percent of all outstanding loans. However, the opposition Democratic party contends that the true tally is closer to ¥100 trillion. Merrill Lynch Japan analyst Koyo Ozeki calculates banks’ unreserved losses on nonperforming loans at ¥40 trillion, or slightly less than their total capital. But if the economy keeps on deteriorating, says Ozeki, the toll could exceed ¥60 trillion. Planners at one major bank dismiss such estimates as apocalyptic: It’s what might happen if every single heavily indebted company in Japan were to go bankrupt overnight, they say.
Yet even going by the no doubt understated official figure, Japanese banks and other deposit-taking institutions’ problem loans add up to the equivalent of 8.8 percent of the country’s GDP. At the height of the U.S. banking crisis of the early 1990s, doubtful loans came to less than 3 percent of America’s GDP. Japan’s bank-loan crisis is thus a far bigger threat to the country’s stability than was the U.S. banking crisis to America’s, says Yasuhisa Shiozaki, a member of Koizumi’s Liberal Democratic party and a former BOJ official.
Three years ago Hakuo Yanagisawa, the gruff ex-Finance Ministry bureaucrat who is Japan’s minister of financial services, averted a major financial crisis by swiftly nationalizing a pair of insolvent long-term credit banks and pushing through legislation to allow public funds to be used to recapitalize other purportedly healthy banks. These decisive moves eliminated the notorious “Japan premium” that the country’s banks had been made to pay to borrow in London’s interbank market and helped spur a rebound in Japanese stocks that propelled the Nikkei to 20,800 in the spring of 2000.
So analysts reacted enthusiastically last December when Yanagisawa, who had first served under former prime minister Keizo Obuchi, was reinstated as the top cop on the banking beat by Prime Minister Koizumi.
But the hero of the credit bank crisis has lost much of his commanding aura. Paradoxically, Yanagisawa’s very unflappability - he prides himself on keeping his cool under fire - may be his greatest liability: Like many other Japanese politicians, the 66-year-old Yanagisawa appears to suffer from what a senior adviser to Prime Minister Koizumi has called “ideological inertia.” Speaking to foreign journalists in June, the FSA chief waved off any suggestion that the Japanese banks’ bad-loan situation was slipping out of control. All the banking industry needed, Yanagisawa declared, was for its debt problem to be assessed “in a steady and cool manner.” Reiterating the government line, he categorically ruled out using public money to resolve the bad-debt problem. It went unsaid, but the inconvenient fact is that bailouts would compel banks’ top executives to resign, and many of them have loyal friends within Yanagisawa’s ruling Liberal Democratic party.
Instead, Yanagisawa called last spring for Japan’s 15 major banks to write off ¥11.7 trillion of bankrupt and near-bankrupt loans over the next couple of years and any newly discovered nonperforming loans over three years. Then in late August he unveiled a revised version of his quasivoluntary debt initiative, proposing that major banks write off half of all nonperforming loans over a seven-year period. This new initiative covers doubtful as well as bankrupt and near-bankrupt loans at the 15 banks, ¥17 trillion worth in all, according to the FSA.
But Yanagisawa has had little to say about how banks are supposed to finance write-offs - or how they should handle a potential deluge of new nonperforming loans as the economy sinks further. A significant proportion of an estimated ¥78 trillion in troubled sonota yo chui saki, or general watch, loans now appears to be at grave risk of sinking to nonperforming status.
To put this into some perspective, Japan’s regulators divide bank loans into five broad classifications. At the top come the seijo, or normal, loans. Directly beneath them are the sonota yo chui saki loans, which are usually described as “loans to borrowers requiring attention.” In third position are yo kanri saki loans, or loans to borrowers requiring special attention. At the bottom are hattan kennen (virtually bankrupt) and hattan (bankrupt) loans. The last three categories count as nonperforming loans that demand specific provisioning.
The FSA contends that surveys of major banks show that only 8 percent of sonota yo chui saki loans “migrated” downward to yo kanri saki, or nonperforming, status in 2000, while 10 percent actually moved up to seijo status.
But these figures are vehemently disputed by Yukio Edano, a member of the Democratic party who has made a close study of the banks’ loan plight. Edano says that seven out of ten corporate bankruptcies in 2000 involved companies classified by banks as either sonota yo chui saki or seijo just one year before they failed. He estimates that a high proportion of loans deemed to be sonota yo chui saki should be declared nonperforming. Moreover, says Edano, a “correct recognition” of the bad-loan problem might force the government to nationalize up to half of all Japan’s so-called city, or national, banks because they wouldn’t otherwise be able to cope with their true liabilities.
Hirofumi Gomi, head of the Inspection Bureau at the FSA, concedes that many companies that failed during the past year had been quite recently classified as “normal borrowers.” But he contends that no direct connection exists between this and the current quality of banks’ loan books. “The underlying problem,” says Gomi “is that the failure of one big company in an industry like construction can lead to a chain reaction of smaller failures.”
Included in the sonota yo chui saki category are a number of heavily indebted major companies that appear to stay afloat only because banks keep rolling over their debt. According to credit rating agencies that have had the chance to scrutinize banks’ loan books, construction companies figure prominently in this group; they are said to include Aoki Corp., Fujita Corp., Hazama Corp., Kumagai Gumi Co., Mitsui Construction Co. and Tokyu Construction Co. All have either been beneficiaries of debt forgiveness in the past year or are burdened with debts exceeding ¥200 billion.
“Japan has huge excess capacity in the construction industry,” says Goldman, Sachs & Co. analyst David Atkinson. “It’s obvious that the banks are keeping alive a large chunk of the Japanese economy that has no real reason to exist.” He estimates that of Japan’s 600,000 construction companies, roughly two thirds are superfluous. Atkinson calculates that just five industries account for 85 percent of all nonperforming loans (but only 56 percent of total loans): construction, retailing, real estate, services and nonbank finance.
More realistic provisioning is no doubt critical, but it’s also painful for the banks. For nonperforming yo kanri saki debts, they must reserve 15 percent of a loan’s face value out of precious capital; for questionable sonota yo chui saki loans, the standard is whatever a bank reasonably thinks it should be (which explains why provisioning varies so strikingly across banks).
One rating agency, which recently downgraded all Japanese banks except for a single small one, reckons the cost to the top 15 banks of making provisions against declared and de facto nonperforming loans could range anywhere from ¥4 trillion to ¥17 trillion, depending on what happens with the Japanese economy over the next couple of years.
Bank of Tokyo-Mitsubishi gave a dramatic demonstration of how fine the line between troubled sonota yo chui saki loans and nonperforming yo kanri saki loans can be when it disclosed in May that its bad loans for fiscal 2000 had jumped by 88 percent, to ¥3.4 trillion. The chief reason: The bank chose to shift more than ¥1 trillion in loans from sonota yo chui saki to yo kanri saki to uphold its reputation as the soundest of Japan’s major banks.
But the price BOTM paid for its calculated prudence was having to set aside extra loan-loss provisions. This in turn forced the bank to declare a pretax loss of ¥225.3 million for fiscal 2000, rather than the ¥60 billion profit it had originally forecast. BOTM also came in for bitter criticism from fellow banks, which have resisted downgrading their sonota yo chui saki loans and feared that the No. 4 banking group’s initiative would bring inspectors round their door.
Yanagisawa’s mildly enforced write-off program hasn’t done much to reassure the markets. Net operating profits at the big banks have fallen short of their loan-loss costs every year since 1993. Gains from securities sales basically paid for the write-offs. HSBC Securities analyst Brian Waterhouse calculates that the 15 major banks accumulated ¥3.3 trillion of new nonperforming loans in just the second half of fiscal 2000, which ended in April, while their core business profits for the whole year - before any loan write-offs - added up to ¥3.6 trillion.
The banks have been able to bridge the shortfall between the cost of disposing of nonperforming loans and their dwindling profits by dipping into their vast stock portfolios. But with the Nikkei index at a 17-year low of under 11,000, almost all major banks have suffered significant portfolio losses, making stocks sales much less feasible as a tool for financing write-offs.
Indeed, newly implemented accounting rules have for the first time forced banks and other corporations to mark securities to market rather than carry them on the books at their purchase price. This has eroded the banks’ capital position just when they’re most vulnerable. Since the end of March, when banks last closed their books, Japan’s stock market has fallen by about 25 percent. Mizuho Holdings, the largest of four megabanks that emerged from a recent series of mergers, reports that its losses on stock sales and realized stock valuations for the half year ended this September are about ¥170 billion; Mitsubishi Tokyo Financial Group, another megabank alliance, which includes Bank of Tokyo-Mitsubishi, tabulates the toll on its portfolio at ¥417 billion.
Regulators insist that the on-paper portfolio losses won’t endanger the banks’ basic health. And any recovery in the stock market would repair some of the damage before the banks’ current fiscal year expires next March. Nevertheless, the mark-to-market rule complicates the banks’ debt mop-up mission because it puts extra strain on their balance sheets and diminishes the profits they need to write off bad loans. Banks must subtract from their capital a portion of the net losses on their securities portfolios and also record losses on their profit and loss statements for any stocks that have fallen 50 percent or more.
The government’s Resolution and Collection Corp. is supposed to help banks get rid of bad debt once and for all. Formed to collect on loans by specialized housing loan corporations that failed in the mid-1990s, the RCC can borrow up to ¥5 trillion from its parent body, the Deposit Insurance Corp., to buy loans in the bankrupt or virtually bankrupt categories from banks. A law drafted in late October by the LDP and its two coalition partners, the New Komeito party and the conservative Hoshuto party, encourages the RCC to buy loans at “market value” and to reimburse itself by selling collateral within three years.
It’s by no means clear, however, what the government means by market value, according to Masami Takesue, head of the RCC Secretariat. He also believes that the RCC may have trouble competing with private sector buyers of nonperforming loans if it’s not allowed to take a loss when the time comes to collect on the loans or sell collateral. The best that can be said for the new system, say analysts, is that the RCC has paid only nominal amounts for the loans it has bought so far, with the result that banks have offered it virtually worthless paper.
FSA minister Yanagisawa’s own passivity on the loan crisis seems not only out of character for him but also out of sync with Prime Minister Koizumi’s honebuto - literally, big-boned - economic reforms. In a speech setting forth the honebuto agenda last June, Economy Minister Takenaka affirmed that the first step toward Japan’s economic revitalization was “definite and final disposal of nonperforming loans.” And he promised “appropriate disclosure of information about the financial condition of companies burdened with excessive debts.”
Precious little action has taken place on either front. Indeed, progress on nonperforming loans has lagged conspicuously behind that on other reforms. Eisuke Sakakibara, who won international fame as “Mr. Yen” in the late 1990s when he was in charge of the Ministry of Finance’s foreign exchange policy, argues that this stems from a fundamental flaw in the Koizumi reforms.
“The nonperforming-loan problem is a private sector issue,” says Sakakibara, who now heads the Global Security Research Center, a think tank affiliated with Keio University in Tokyo. “It is linked to the dual structure of Japan’s economy, which is split between relatively efficient export industries and highly inefficient and debt-ridden domestic industries like construction and retailing.” Koizumi’s reforms, he says, “virtually ignore” the private sector and focus instead on privatizing or abolishing large and unprofitable state-owned entities, like Japan National Oil Corp. and the Government Housing Loan Corp. These may have outlived their usefulness, Sakakibara says, but their huge debts are held by the government, not by banks, so this strategy does nothing to solve the latter’s bad-debt woes.
More disturbing to some analysts than any shortcomings of the Koizumi reforms are signs that Yanagisawa - who should be “Mr. Debt,” just as Sakakibara was Mr. Yen - does not determine policy at his own agency. Another former top BOJ official says that when Yanagisawa “dithered” and then refused to use public money to finance a quick write-off of nonperforming loans when he returned to the FSA in December 2000, it was because he was overruled by senior officials at the agency, notably commissioner Shoji Mori, the FSA’s top bureaucrat. These “soft-liners” balked at using public money to bail out banks and then having to sack their senior managers, many of whom have powerful political allies.
Yanagisawa can’t help but be aware of political pressures. In October 1999 during his first tour as minister of financial services, he was dropped in a cabinet reshuffle, purportedly because he’d gone too far in trying to close down two heavily indebted major banks.
Thus, despite Yanagisawa’s reputation for toughness, says former MoF vice minister Gyohten, “he simply doesn’t have the clout” to do the job. If banks can’t or won’t write off their uncollateralized balances in the next three years, they should be nationalized and their senior managers dismissed, says Gyohten, who now heads the Institute of International Monetary Affairs, a Tokyo think tank. But he admits that no one in the government or the Bank of Japan today can go head-to-head with the president of a big bank and “quietly but firmly advise him to quit.”
And history is not on Yanagisawa’s side. The peculiarly Japanese ties between banks, bureaucrats, banks and big business would appear to make it all but impossible for regulators or even like-minded politicians to hack their way through the thicket of nonperforming loans. Labeled “socialized capitalism” by Akio Mikuni, the founder of Japan’s first independent bond rating agency, this collaborative or collusive (depending on one’s perspective) arrangement dates to the post-World War II period when the government designated the banking industry as its chosen instrument for developing strategic industries.
Strict constraints on the development of capital markets ensured that companies had to rely on banks for operating capital; the banks in turn had to follow “window guidance” by the Bank of Japan as to how much they could lend. Deterred from investing in stocks, Japanese individuals channeled most of their savings into bank deposits or life insurance policies. Insurers also made loans to industry.
This “socialized credit” system helped to transform Japan into an export powerhouse. But by the second half of the 1980s, it was being abused to generate overcapacity in most manufacturing industries. Profits suffered. The MoF’s response was to encourage banks to lend to real estate developers, on the theory that land prices in overcrowded Japan couldn’t go anywhere but up. Then when the real estate market turned down in 1990, the MoF, assuming that the fall was temporary, urged banks to roll over their loans rather than call them or force borrowers into bankruptcy.
When this proved to be an epic misjudgment, the MoF’s banking bureau invoked an array of unofficial and extralegal powers to try to patch up the system by forcing healthy banks to rescue weaker ones. In March 1997, for instance, the banking bureau masterminded the rescue of Nippon Credit Bank with a ¥300 billion recapitalization. But the following November, the MoF failed to dispatch a rescue team in time to prevent the collapse of Japan’s tenth-largest bank, Hokkaido Takushoku Bank - a major embarrassment for the Ministry.
Fifteen months later the MoF’s once-mighty banking bureau was out of a job. It had been merged with the MoF’s securities bureau to form a financial system planning unit, which was responsible for policy but no longer for regulation. The task of inspecting and regulating banks was passed to the newly created Financial Services Agency. The separation of regulatory and policy functions brought Japan belatedly into line with other developed countries.
But after years of cozy relations between bankers and bureaucrats, the FSA has had a hard time playing tough cop. It decided early on not to pick up staff from the MoF’s discredited regulatory division. However, this left it seriously short of inspectors, as it remains today. Contrast the FSA’s 360 inspectors with the 6,000 or so who were working for the Federal Reserve Board and other regulatory bodies at the height of the U.S. savings and loan crisis.
The FSA didn’t even have an inspection manual to start off. The MoF had never needed one, since its inspectors liked to discuss the quality of banks’ loan books informally, preferably over drinks at the ritzy restaurants in Akasaka, near the government ministries in Kasumigaseki. FSA inspectors, their newly compiled manuals in hand, completed their first full inspection of a major bank in 1999 and have now covered all but five of the 15 major banks - forcing the ten to declare more of their loans nonperforming.
Bankers don’t believe that they should be made the scapegoats for Japan’s economic travails. “It’s not nonperforming loans that are dragging down the economy, it’s deflation that is pushing up bad loans,” insists a senior official in the loan policy planning department of Mizuho. A senior planner at United Financial of Japan, another megabank, contends that far from being the culprits, banks are warding off economic disaster by exercising forbearance. “If the banks were to get really tough with the construction industry,” says this executive, “we could easily put 5 million people out of work,” sticking the government with a bill for unemployment benefits of ¥15 trillion.
Bankers are pleading for more time to dig their way out of the debt morass and complain that they’re at a disadvantage in competing for business with government-owned banks. “We’d like to raise loan spreads to generate earnings that would allow us to increase provisioning on monitored loans,” says Nobuaki Kurumatani, head of planning at the recently formed megabank Sumitomo Mitsui Banking Corp. But that is not so easy to do, he says, when government entities skim off some of the most profitable lending business. The state-owned (and heavily subsidized) Government Housing Loan Corp. has assets of ¥70 trillion, compared with the ¥10 trillion of housing loans held by the four largest banking groups. Some banks contend that they could boost their profits by 50 to 60 percent if they had the business that currently resides with the state financial institutions.
But banks don’t have the luxury of a lot of time to bail themselves out. The FSA’s seven-year timetable for the big banks to halve their bad loans needs to be juxtaposed against another Tokyo deadline: April 2002, which marks the end of the government’s blanket guarantee on all deposits at all banks. On that date, the Deposit Insurance Corp. will introduce a payoff system under which depositors at failed banks can count on being reimbursed for no more than ¥10 million. Also from April onward, the DIC will stand by to take over failed banks through a so-called purchase-and-assumption procedure that has yet to be tested. The prospect of the payoff scheme has already sparked a flight of deposits from weaker banks, says Johsen Takahashi, senior counselor at Mitsubishi Research Institute. The exodus is certain to intensify as the April imposition date nears.
Capital flight combined with worsening deflation and sharp economic contraction caused in part by collapsing exports to the U.S. could create financial turmoil in Japan comparable to - or worse than - the 1998 Asian financial crisis, warns Takahashi. The economist believes that “if we don’t begin to solve our problems by early next spring, this country will face its worst situation in the 56 years since the end of World War II.” Other observers may give it more time, but few dispute the potential scope of the impending crisis.
Debt detective
Hirofumi Gomi, who heads the bank-inspection division of Japan’s Financial Services Agency, likens his role to that of Ichiro Suzuki, the Seattle Mariners baseball star and Japanese sports icon. “I like to think of myself as No. 51,” he says. Like “Ichiro” roving the outfield with sure hands, Gomi doesn’t like to let anything get by him. He has a reputation among bankers as a tough loan examiner. And the government has just given the FSA’s inspectors new authority to investigate banks annually and in emergencies (story).
But, switching metaphors, Gomi suggests that the purpose of the FSA inspection bureau is akin to that of a hospital X-ray department. “It’s up to us to provide an accurate picture of the patient’s condition,” he explains. “But someone else has to decide what to do about it.”
During his first three months on the job, Gomi’s biggest challenge has been to find a way to bridge the gap between banks and the FSA on how to distinguish between yo kanri saki (special watch) loans, which require banks to make specific loan-loss provisions, and sonota yo chui saki (general watch) loans, which involve potentially troubled borrowers but aren’t officially nonperforming and thus don’t require specific provisioning.
The yo kanri saki category includes restructured loans, and bankers and the FSA often don’t agree on what “restructured” means. As Gomi interprets the term, it applies to any loan that has been rolled over with its conditions unchanged if the borrower has suffered a credit downgrade since the loan was issued. “We’ve been saying that since the FSA manual was published two years ago,” he explains, “but banks haven’t seen it that way.” They say it’s their job to support any borrower that can pay some interest even if that borrower can’t pay back the principal.
These differing interpretations help explain why bankers and regulators are typically 25 percent apart in their estimates of nonperforming loans. Neverthless, Gomi rejects the view that all sonota yo chui saki loans should be reclassified as nonperforming and dealt with accordingly, as he prefers to preserve distinctions and recognizes how hard this would be on banks.
Gomi also candidly contends that no direct connection exists between the quality of a bank’s loan book, as certified by FSA inspectors, and the proportion of the bank’s borrowers that subsequently go bankrupt. “What we are doing is to describe the situation as it is today,” he says. “It’s not our fault if the deteriorating economy means that good companies suddenly become bad companies.”
Until the late 1990s banks habitually “reduced” their nonperforming loans simply by transferring them to nonbank affiliates and classifying the affiliates as normal borrowers. “We may still have problems,” says Gomi, “but at least we’ve put a stop to that.”
