What's next for Japanese banks?

As the Nikkei index vacillates and bank assets deteriorate, Japan needs to take a close look at the fundamentals of its financial system.

The economic success that Japan enjoyed following World War II depended on its ability to produce high-quality products at low cost to the consumer. Japan operated very much on a high-volume, low-margin basis, with a long-term approach to business development. This approach was possible because of a strong work ethic and a very close relationship among corporate entities, the government, and the banking system. As we know only too well, the system worked well--that is, until the Japanese economic bubble started to break in 1990.

The bubble began to form in 1986, when Japanese government officials introduced an easy money policy in an attempt to strengthen the yen and bring down soaring trade surpluses. The low-cost capital unleashed a flood of lending and speculative activity on the stock market, which soared past 39,000 yen on the Nikkei index at its peak in December 1989.

As the market went up, banks became heavy lenders, investing primarily in real estate not only in Japan but around the world. Also investing heavily in real estate and other "bubble" sectors (the stock market and art, among the most notable) were the non-bank financial companies, many of them set up by the banks and by traditionally conservative manufacturing companies. Real estate prices went through the roof.

In the spring of 1987, Japan's regulatory authorities moved to clamp down on speculation and illegal financial activities. The Bank of Japan drained liquidity from the money markets and pushed up interest rates, and the Ministry Of Finance (MOF) indicated that it would tighten bank accounting and regulatory standards. But following Black Monday in the U.S. in October 1987, the world feared a severe economic depression. Japan's central bank eased money once again, and the MOF put its reforms on hold.

Then, in 1989, in response to increasing abuses in the system and highly inflated real estate prices, the Bank of Japan again tightened monetary policy, leading ultimately to a severe correction in stock prices early in 1990. This, combined with the outbreak of hostilities in the Middle East, caused stock prices to fall nearly 50 percent from December 1989 to September 1990. Since then, the Nikkei dropped another 20 percent, although, as this article goes to press within days of the Japanese government's announcement of its new package to stimulate the economy, the market is more uoyant.

At about the same time that the central bank tightened money in 1989, the MOF imposed limitations on new financing for real estate. The result of all of this was downward pressure on real estate prices--and a serious cash flow squeeze for many of the most aggressive bubble companies. For the first time in almost 20 years, real estate prices in Japan dropped. The government reported that last year, land prices were down about 5.5 percent. In reality, however, the drop was much greater. It's difficult to determine where equilibrium exists in the overall market because there are so few transactions. Further obscuring the picture is the fact that prices vary dramatically from sector to sector. In Osaka, for example, the depreciation of condominium values over the last 18 months was estimated to be 40 to 50 percent.

Yet, even through 1991, despite lower overall lending growth, banks allocated a large percentage of their funds directly and indirectly to the real estate market.

BANK INEFFICIENCY

One of the major factors contributing to the escalation of speculation in Japan--and that now puts the Japanese banks at risk--is the main bank concept. Japanese banks are precluded by the MOF from holding more than 5 percent of the shares of non-bank companies. So they own 5 percent of a securities firm, 5 percent of a finance company, 5 percent of a variety of institutions. Even though the banks have limited ownership of the non-bank companies, these companies are nevertheless considered to be bank affiliates. The result is that borrowers with main bank connections can access huge amounts of funds not only from their main bank, but also from other financial intermediaries who rely on the implicit credit guarantee of the main bank. Ultimately the main banks have become the guarantors of a majority of the finance companies in the marketplace.

So what happened? When real estate prices spiraled up, the finance firms were lending aggressively to speculative real estate developers. Total assets of the non-bank finance companies ballooned to about 100 trillion yen (about $750 billion). Today, of course, these companies are unwinding quickly. According to an MOF report to the government earlier this year, 60 percent of Japan's top 300 non-banks had delinquency rates of 10 percent of their total assets, and the vast majority of these firms experienced a three-fold increase in delinquency levels within the past year alone. The main banks have enormous direct and indirect exposure in these companies, and their asset quality is quickly deteriorating.

Traditionally, of course, one of the strengths of the Japanese system was that its banks had strong asset quality--largely because they didn't have investment problems outside Japan, and because the Japanese economy was so strong. Neither is true any longer.

The Japanese banking system is weak in other ways. Bankers still lend very much on name and collateral. Up until 10 years ago, in fact, it was not unusual for a bank's exposure to a single company to equal 50 or even 75 percent of its capital. While there are now legal lending limits--20 percent to 30 percent, depending on the circumstances--the banks are still heavily exposed. And, when borrowers get into problems, banks start rehabilitation proceedings, frequently sending in management and additional capital.

This leads to another major problem in the Japanese banking system: lack of adequate disclosure. It is very difficult to get an accurate assessment of what is really going on. First, the Japanese do not report non-performing loans until they are 180 days past due, whereas in the U.S. non-performing loans are reported at 90 days past due. Second, they report loans net of collateral. And finally, because everything is so intertwined through the main bank system, until a given transaction works its way through the entire system, it's hard to determine what its effect will be.

Inadequate disclosure, combined with weak consolidation requirements and liberal accounting practices, aided the incidence of fraud within the system through insider trading, stock price manipulation, and compensation of losses to favored clients. And, when all of this was combined with the escalating stock market and questionable banking practices, such as the massive buildup of borrower debt levels based principally on inflated asset values rather than on the borrowers' cash-flow servicing capacity, the result is the massive debt overhang the banks have today.

The international financial marketplace is saying that it has limited access to reliable information on which to base credit decisions, and that credibility in the marketplace requires accurate disclosure. Some regulatory officials in Japan are pushing for better disclosure, so I think we will get better information. But it will be nothing like the full disclosure we have in the U.S.

What level of bad debt are we talking about for these banks? Ministry of Finance regulators have placed it at 8 trillion yen, which is about $60 billion, a fairly modest number. But this estimate is probably understated because of inadequate disclosure. In fact, some analysts have estimated the problem debt figure to be as high as 50 trillion yen (roughly $400 billion).

IS THERE A SOLUTION?

Where does all this lead? Much depends, of course, on what happens to the Japanese economy. The Japanese government had anticipated that the economy would grow 3.5 percent this year. So far it has fallen short of that goal. The government lowered the discount rate again earlier this year to boost the stock market, but with little effect. So in August it announced several policy initiatives to strengthen the stock and real estate markets, as well as to jump-start the economy in the short term. At this writing, it's too early to estimate how successful these programs will be, but they are clear evidence of the government's growing concern about the banks and the economy and its belated recognition of the severity of the country's problems.

I am confident that the situation will ultimately work itself through, barring any unforseen disaster for the economy. But lack of disclosure and the way the banks deal with problems--by absorbing them, by using affiliates, by creating companies--doesn't reveal what the reality is. According to government officials, some of the local and regional banks are in the most trouble. They claim that the major banks, supported by substantial hidden reserves, are still solid. The government reports that total hidden reserves of the major banks, even discounting 55 percent of their value in accordance with BIS (Bank for International Settlements) guidelines (described in the following paragraph), are almost equal to their combined equity capital. But if the stock market continues to decline, obviously, the value of these reserves will continue to deteriorate. And outside observers are concerned that even some of the major banks are in difficulty. (See Bank Watch ratings on page 26.)

The focus on hidden reserves in the capital guidelines set by the BIS is likely to exacerbate the problem. These guidelines call for banks to meet an 8-percent total capital ratio (capital as a percentage of risk-adjusted assets) by March 1993. When the BIS came up with these guidelines in the late 1980s, it accommodated the Japanese hidden reserves by letting Japanese banks count 45 percent of their stock market holdings in their reserves for capital.

But if the Nikkei should begin another decline, many of these banks will be under pressure to comply with the minimum BIS guideline of 8 percent. When next March rolls around, the banks are going to have to shrink their assets or raise additional capital to make that 8 percent unless the stock market improves. That's going to make a bad situation worse.

Our view is that the BIS guidelines are not an appropriate measure of capital adequacy. They do not differentiate the quality of assets. My recommendation is that we redefine the BIS ratio to focus on real capital. Let's give these banks two or three years to build up their capital again and eliminate hidden reserves in the determination of capital. That is not to say, however, that they should be allowed to do what they did in 1987. When the stock market went up then, they kept growing when they should have been slowing down. Had they slowed down then, they probably would not have the problems they now have.

In the meantime, anticipating the 8-percent ratio, Japanese banks are pulling back. Indeed, many borrowers are already seeing higher prices from the Japanese. And there's no question that Japanese banks are pulling back at a time when most international markets need more, not less, liquidity. That's especially a problem in the U.S. and the U.K.

And it will cause even more problems for the Japanese economy in its effort to grow at 3.5 percent. The banks reported much wider interest spreads in lending activities for the fiscal year that ended in March compared with previous years. And estimates indicate this trend will continue throughout the current fiscal year. Japanese banks, in the best of times, were low-profit and highly leveraged; but they can't operate this way any more now that they're part of the global economy and follow BIS guidelines.

What does all of this mean for the U.S.? Japanese banks have no choice but to shrink their balance sheets, and they certainly don't want to do so in Japan. Nor, because they see opportunity there, do they want to withdraw from the Asia Pacific arena. There isn't as much competition for them there, for one thing, as the Americans and other foreign institutions have pared back their international operations. So, in all likelihood, the Japanese will be more selective in their lending activities in the U.S. and Europe. But we do not expect to see any of the major banks pull out entirely.

THE NEW CONSOLIDATIONS

With the Japanese economy in disarray, there will be considerable pressure on the banks to perform in the next three to five years. So, with the weaknesses in the banking system and the continuing deterioration of their assets, Japanese banks will continue to liquidate some of their hidden reserves. And they'll be consolidating.

The effectiveness of consolidations, however, will be muted by the tradition in Japan of lifetime employment. When two major city banks, Taiyo Kobe and Mitsui, merged in 1990, they didn't really consolidate their operations and reduce their cost structure by closing branches and laying off employees. Instead, they have twice as many branches and twice as many people. As long as these practices continue, Japanese banks are going to have overhead problems.

There will also be a major realignment between the banks and the securities firms. Banks are starting to trade in securities to develop non-lending sources of revenue. As banks enter the securities field, there will be, over the next three to five years, a shake-up in the securities firms. The only securities firms to survive will be those with strong capital, such as Nomura, Daiwa, and perhaps Nikko.

There will also be a realignment in the three banking groups: the city banks, which are commercial banks; the long-term credit banks; and the trust banks, which were enormously successful as a result of the bullish stock market of the 1980s and escalating real estate activity. We will probably see some mergers across these groups of banks in the next several years, clearly an indication of the breakdown and modernization of the traditional system.

As part of the process of consolidation, the major banks will continue to take on the problems of the weaker institutions. Japan has the too-big-to-fail syndrome, and so the healthy banks have to shore up the less healthy institutions. The result could be a further drain on the healthy banks. But it is clear that the government is going to support the banks and the banking sector in any way it can. As we have seen, officials will work to lower interest rates, provide support funding, and do whatever is necessary to resolve what is seen as a systemic issue.

To my mind, the government's continuing to bail out weak institutions will just prolong the problem, as we saw with the savings and loans in the U.S. It's better to deal with the problems now.

HAPPY LANDINGS?

There is a need for fundamental changes in Japan's economy and financial system. The banking system cannot continue to operate as it has in the past--with high-volume, low-margin lending operations--and still be successful in the global economy. It could function that way in the 1970s because the economy was still growing. In the 1980s, everyone had money. But the 1990s present a different world.

I'm not sure the Japanese understand that. That they must constantly adapt and adjust as conditions change. But they cannot continue to operate on their own and ignore the rest of the world. At the moment they see just a short-term bubble, and think that once they work out the real estate problems, everything will go back to normal. Unless they are willing to recognize things are fundamentally wrong in their system, there will be a much harder landing some place down the road.

To sum up, on the one hand, I'm positive that the Japanese banking system will survive. On the other hand, the problems of the system are very significant and are not going to go away anytime soon. My hope is that the Japanese will use this as a period of change, that they will tighten up their accounting and regulatory procedures and provide more, and more reliable, information to the credit markets. And that they will recognize soon the basic changes they need to make to participate in the global marketplace.

[Mr. Root is president of Thomson BankWatch, Inc., a division of the Thomson Corporation.]