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Deposit guarantees and the burst of the Japanese bubble economy.

I. INTRODUCTION

This paper describes the current status of deposit insurance systems in Japan and reviews the history of deposit guarantees in the past several years. During this period, some of the Japanese financial institutions have faced near or outright insolvency for the first time in the postwar history. This paper gathers publicly available data and facts on deposit guarantees in Japan in order to gain perspective on the problems.

II. BUBBLE, BURST Of THE BUBBLE, AND FINANCIAL DETERIORATION

The Japanese economy of the second half of the 1980s is commonly known as a "bubble economy" while the first half of the 1990s is known as the burst of the bubble economy. Starting in 1986, asset prices including stock and land, fine art paintings, and country club memberships doubled and then tripled within a few years. Following the peak in 1989, asset prices rapidly came down in the first half of the 1990s. Stock prices declined by 60 percent from 1990 to August 1992. Even as late as Spring 1995, stock prices remained at about half of the peak level. Representative land prices in metropolitan areas also declined by half from 1991 to 1995.

In retrospect, the rise and fall of asset prices from 1985 to 1995 is a typical financial bubble, but one that rivals many other spectacular examples in history. The burst of the bubble in the first half of the 1990s left many corporations, especially in the real estate business, holding large debts without sufficient earnings from properties to service outstanding loans. The financial deterioration, manifested by a nonperforming loan problem of major proportions, is Japan's most serious financial challenge in the postwar period.

The total size of the nonperforming loan problem is open to debate. In July 1995, the Ministry of Finance reported that Japanese banks and other creditors held about [yen]40 trillion worth of nonperforming loans of which 30 percent were regarded as uncollectible. The Ministry further indicated that another [yen]8 trillion in loans were "questionable" if one applies a more rigorous definition of "nonperforming loans." This qualification made the total estimate of nonperforming loans [yen]48 trillion.(1) Of this amount, the 21 major banks - consisting of the 11 city banks, three long-term credit banks, and seven trust banks - held approximately [yen]23 trillion. As a result, credit rating agencies have continually downgraded Japanese banks, once regarded as among the most financially secure in the world. In August 1995, Moody's released a new rating system for the major Japanese banks. The new rating system is designed to rate banks on a "stand alone" basis without government support and gives the top 50 Japanese banks an average rating of D because of weak fundamentals and earning powers.

The financial press and regulatory authorities have focused on the bank nonperforming loans held by banks and housing loan companies or jusen. However, the nonperforming loans held by credit cooperatives represent a serious though less publicized problem because of their relatively small capital base. Their similarity to S&Ls in the United States is intriguing. Many observers (e.g., Ostrom, 1992; Cargill, 1993; Kane, 1993) have drawn several parallels between the credit cooperatives in Japan and the S&Ls in the United States. These parallels include the following: (i) Agricultural credit cooperatives have diversified significantly away from their traditional specialization on loans to farmers related to agricultural operations. (ii) Some credit cooperatives have strong ties to the local community and politicians. (iii) Credit cooperatives hold significant amounts of real estate related loans. (iv) Credit cooperatives are not directly supervised by the Ministry of Finance or Bank of Japan but by local prefectural governments such that the extent and sophistication of local supervision is likely uneven. Some credit cooperatives have diversified without adequate supervision. In a sense, the greatest risk of financial breakdown and contagion resides in these small institutions because of their vulnerability.

From December 1994 to the summer of 1995, the Ministry of Finance for the first time in the postwar period had to officially depart from its "no failure" policy and declare depository institutions insolvent unless they merged with (without being merged to) another institution. Moreover, highly publicized deposit withdrawals have triggered official declarations of insolvency in the Cosmo and Kizu Credit Cooperatives. In the summer of 1995, three insolvencies - Cosmo and Kizu Credit Cooperatives and Hyogo Bank - combined with several earlier assisted mergers since 1991 exhausted the resources of the Deposit Insurance Corporation, Japan's most important deposit insurance agency.

The regulatory reaction to the asset deterioration and insolvency problems is reminiscent of the slow regulatory response to the deterioration of asset quality in the U.S. S&L industry. Japanese regulatory authorities have adopted the same policy posture as did U.S. regulatory authorities in the 1980s: denial of the problem; understatement of the problem once denials were no longer credible; forbearance and forgiveness; use of public funds (broadly defined) to shore up insolvent or close to insolvent institutions in order to give them time to "work their way out of the problem"; and administration of the deposit guarantee system that enhances moral hazard.

The collapse of asset prices not only created the current financial problem in Japan but is responsible for Japan's most prolonged postwar recession which in turn, has exacerbated the nonperforming loan problem.

The legacy of nonperforming loans, weaknesses revealed in Japan's financial structure, and weaknesses revealed in Japan's regulatory structure most likely will affect the economy in years to come. The more optimistic projections made for Japanese financial liberalization in the recent past (see Cargill and Royama, 1988) now must be revised downward. Japanese regulatory authorities have been slow to accept the lessons of the U.S. experience in dealing with their own conflicts between liberalization and incentives to assume risk.

III. THE BUBBLE ECONOMY: FINANCIAL LIBERALIZATION, SPECIAL FEATURES, AND DEPOSIT GUARANTEES

The bubble phase of the 1980s was the result of several interacting forces: initial change in fundamentals that justified increased asset prices, accommodating monetary policy, financial liberalization, special features of the Japanese financial system, a pervasive system of deposit guarantees, and a stochastic process that permitted asset prices to deviate further and further from fundamentals. Assigning specific responsibility is impossible since all elements played an interacting role. However, one can trace the burst of the bubble economy to a shift toward tight monetary policy in May 1989 in the context of land and equity market sensitivity to disruption in the flow of funds.

The coincidence of financial liberalization and asset inflation and deflation has led a number of observers to argue that liberalization played a major role in the financial disruptions of the 1980s and in the problems of the 1990s inherited from the boom and bust period (e.g., Borio et al., 1994; Nakajima and Taguchi, 1993). The analysis here is rooted in the traditional argument that unregulated and competitive banking is inherently unstable. Thus, in the context of liberalization in the 1980s, the removal of binding portfolio constraints without strengthened supervision permitted banks and other depositories to adopt risky and imprudent investment and loan portfolios.

This explanation appears incomplete since the risk incentive nature of government deposit guarantees or "moral hazard" of government deposit guarantees contributes to any explanation of the coincidence of asset inflation and financial liberalization in Japan and elsewhere (see Iwamura, 1993, for a simulation study of this effect). In most cases, the liberalization process in the 1980s failed to change the existing system of government deposit guarantees that had been designed for a more regulated and administratively controlled financial environment. As a result, government deposit guarantees provided incentives to assume risk. At the same time, regulatory and market innovations permitted depositories to manage and assume more risk. In addition, in most cases, regulatory authorities responsible for administering the government deposit guarantee system were subject to perverse incentives in how they dealt with troubled institutions. These incentives encouraged greater risk taking on the part of depository institutions.

The U.S. experience provides the most important parallel case study of the destabilizing aspect of deposit guarantees. In the U.S. experience, deposit insurance failure has been more transparent than elsewhere and detailed microeconomic data on depository behavior is more generally available than elsewhere. However, the risk incentive and agency problems of deposit guarantees have not been empirically investigated in Japan. Fries et al. (1993) provide the notable exception. Additionally, at this time sufficient data are not publicly available to subject the risk incentive issue to extensive empirical testing. At the same time, no evidence exists that Japan's financial system is special or responds differently to incentives than do other systems. Nor does reason exist to doubt that the type of agency problems that accounted for regulatory inertia in dealing with the U.S. S&L crisis are not fully operable in Japan.

The December 1994 failure of two credit cooperatives, Tokyo Kyowa and Anzen Credit Cooperative, offers some insights into the potential for moral hazard in Japan and clearly indicates that Japan's financial system has more in common with the U.S. system and other systems than regulatory authorities are willing to admit.

Observers report that the Ministry of Finance was aware of the insolvency of the two credit cooperatives as early as Spring 1993 through a joint special examination with the Tokyo Metropolitan Government, which has direct supervision authority over credit cooperatives in Tokyo. This knowledge therefore existed almost two years prior to the official declaration of insolvency. Documenting how the delay in closing the two institutions contributed to the ultimate cost of the bailout in early 1995 is a straightforward matter.

The Tokyo Metropolitan Government documents as reported in Asahi Shinbun (daily newspaper, February 16, 1995) publicly revealed that the two credit cooperatives suffered from a classic case of moral hazard in their last two years. Deposits at both institutions increased from [yen]139 billion in March 1992 to [yen]244 billion in November 1994 - that is, at an annual rate of 32 percent, while lending increased from [yen]137 billion to [yen]225 billion or at an annual rate of 22 percent over the same period. The majority of the new loans made during this period ultimately were classified as nonperforming. The total nonperforming loans of the two credit cooperatives increased from [yen]250 billion (out of total loans of [yen]1,371 billion) in March 1992 to [yen]1,769 billion (out of total loans of [yen]1,990 billion) in March 1994. Moreover, unrecoverable losses increased from [yen]65 billion in March 1992 to [yen]1,118 billion in March 1994. Thus, not only did the two credit unions aggressively expand deposits to make new higher risk loans during their decline into insolvency, but total nonperforming loans increased seven-fold and unrecoverable losses increased 16-fold over a two year period from March 1992 to March 1994. In addition, observers widely acknowledged that offering above-market deposit interest rates made possible the rapid increase in deposits.

The portfolio behavior of the two credit cooperatives illustrates the classic response of a private depository in the presence of government deposit guarantees to actual or impending insolvency. Insolvent or close to insolvent institutions "gamble" with depositor funds to "work their way out of the situation." Depositors have little interest in monitoring the portfolio shift because of pervasive deposit guarantees. The tale of the two credit cooperatives mirrors a frequent occurrence during the U.S. S&L crisis.

The literature emphasizes that a deposit insurance system has two aspects: (i) an intended function to prevent a bank run and systemic risk and (ii) a side-effect that causes moral hazard. Regulators find it difficult to use the intended function without suffering from moral hazard. Both U.S. deposit insurance failure in the late 1980s and in the beginning of the 1990s and the current difficulty in Japan illustrate the universality of the problem.

Before the series of credit cooperatives failures in late 1994 and 1995, several authors argued that Japan was missing a chance to learn from the U.S. deposit insurance failure. These authors believed that the U.S. experience could help Japanese policymakers in the future as the financial system continues to progress toward more open and competitive markets. In particular, a major opportunity was missed in 1992 when the Financial System Reform Law was passed to deal with some of these issues. However, as in the past, Japanese regulatory authorities ignored the side effect of deposit guarantees and seemed uninterested in learning the lessons offered by the U.S. experience (Cargill and Todd, 1993; Kane, 1993).

IV. DEPOSIT GUARANTEES IN JAPAN

Japan's system of deposit guarantees consists of four components: (i) An explicit deposit guarantee through the Deposit Insurance Corporation that covers up to [yen]10 million yen per customer in most depository institutions. (ii) Another explicit deposit guarantee in specialized, smaller institutions. (iii) Government guarantees on postal savings with limits on [yen]10 million. (iv) Implicit guarantees on all depository institutions' deposits by the Ministry of Finance and the Bank of Japan. However, before the burst of the bubble economy, the possibility of bank failures was considered so remote that discussions of deposit guarantee were limited.

Japanese financial regulation historically has been operated on the principle of a "no failure" policy (Tachibanaki, 1991) and thus philosophically has been less willing to rely on a deposit insurance framework that explicitly recognizes the possibility of failure. However, conditions in Japan are rapidly changing and forcing a reappraisal of the "no failure" policy.

Deposit guarantees related to the "no failure" policy are broadly interpreted. In the past, the Ministry of Finance has made extraordinary efforts to ensure the health and stability of the financial system even to the extent of bailing out a securities company in 1965. More recently, it has handled public information on the nonperforming loan problem and has accomplished assisted mergers between solvent and insolvent institutions in ways that confirm its protection of the financial system.

Even when the Deposit Insurance Corporation was set up, it was not expected to play a meaningful role in Japan's deposit guarantee system for three reasons: first, banks were subject to extensive administrative guidance that effectively limited risk; second, the overall structure of the financial system insured high rents to banks, rendering failure unlikely; and third, even if a bank problem occurred, arranging a "rescue merger" was easy since the "goodwill value" of the troubled bank's deposit base and branching network was generally large enough to attract merger interest from larger institutions.

Japan's deposit guarantee system has not been tested to the same degree as the guarantee system in the United States though it manifests the same type of policy errors characteristic of the U.S. experience. One can attribute the difference to a variety of factors: (i) Japan's macroeconomic environment had been more conducive to a smooth and gradual evolution toward open and competitive markets, (ii) segmentation of the markets and tight control of entry had guaranteed profits, (iii) price stability generated a smaller gap between regulated and unregulated interest rates and thus provided fewer incentives to innovate, (iv) and regulation and administrative guidance had been more binding in Japan than in other countries.

V. THE DEPOSIT INSURANCE CORPORATION

Japan's largest deposit insurance system, the Deposit Insurance Corporation (DIC), was established July 1971. DIC membership was mandatory for city banks, regional banks, member banks of the second association of regional banks (sogo banks prior to 1989), trust banks, long-term credit banks, shinkin banks, credit cooperations, and labor banks.

The deposit insurance system was restructured in 1986 due to growing concerns with the implications of liberalization for bank risk. The maximum insurance limit was raised to the present level of [yen]10 million; the flat-rate insurance premium was raised to the present level of 0.012 percent of deposits; and the Bank of Japan loan authorization limit was raised ten-fold to the present value of [yen]500 billion. Most important, the DIC was provided with authority to financially assist mergers and acquisitions as a way of protecting depositors as an alternate option to directly paying off depositors in the case of default. Financial assistance is limited to the amount of insurance limit of [yen]10 million or actual amount, whichever is lower for each deposit.

Compared to the U.S. deposit insurance system, the DIC has been grossly underfunded. DIC bank deposit guarantees were approximately equal in Japan and in the United States in terms of the percentage of total deposits insured (table 1 and 2). However, reserve to deposit ratios were significantly lower in Japan (table 1 and 2).

So far the DIC has never paid off depositors directly at a failed institution. However, from 1991 to the summer of 1995, the DIC publicly assisted problem institutions. The details reveal a pattern reminiscent of how the United States dealt with troubled institutions in the late 1970s and early 1980s.

(i) The DIC for the first time in 1991 assisted the merger of the insolvent Toho Sogo Bank with the regional Iyo Bank. The decision to assist the merger was made in October 1991 and was carried out in April 1, 1992. Assistance came in the form of subsidized loans to Iyo Bank of [yen]8 billion over a five year period with an interest rate set at 5 percentage points below the long-term government bond rate. Iyo Bank was referred to as a "white knight" bank because of its willingness to take over the failed Toho Sogo Bank. Iyo Bank shareholders retained ownership rights in that six shares of Toho Sogo equity were exchanged for one share of Iyo Bank equity.

(ii) Toyo Shinkin Bank in Osaka failed as a result of issuing fraudulent certificates of deposit. The DIC provided a cash payment of [yen]20 billion in October 1992 to Sanwa Bank, a large city bank, to acquire the Toyo Shinkin Bank. Again, shareholders of the failed institution retained ownership rights. One and a half shares of Toyo equity were exchanged for one share of Sanwa equity.

(iii) The Iwate Bank acquired the Kamaishi Shinkin Bank in June 1993. The DIC contributed [yen]26 billion in financial assistance in October 1993 to compensate for the fact that Kamaishi Shinkin Bank was insolvent. Instead of adopting an assisted merger, Kamaishi Shinkin Bank was liquidated, and shareholders were not compensated. However, the regional federation of shinkin banks compensated the shareholders for the book value of Kamaishi Shinkin Bank equities.

(iv) The DIC made a financial contribution to Osaka Koyo to absorb Osaka Fumin in March 1994. Unlike the first three cases, Osaka Fumin was a credit cooperative. In exchange for assuming the debts, the DIC gave Osaka Koyo [yen]19.9 billion beginning November 1, 1993. Again, the local federation of credit cooperatives compensated shareholders of the failed institution for the book value of their holdings. The Osaka Metropolitan government gave financial support.

(v) The Credit Cooperative Gifu Shogin failed and was merged with another credit cooperative, Kansai Kogin. The assets of the failed credit cooperative were shifted to another company, and Kansai Kogin was provided with [yen]2.5 billion beginning March 13, 1995.
TABLE 1


DIC: Insured Deposits and Deposit Insurance Fund


a: Percentage of Total Deposits Insured
b: Insurance Fund as Percent of Total Deposits
c: Insurance Fund as Percent of Insured Deposits


Year a b c


1971 89.0 0.004 0.004
1972 88.4 0.008 0.009
1973 89.6 0.012 0.014
1974 89.8 0.017 0.019
1975 90.4 0.020 0.023
1976 90.7 0.024 0.027
1977 90.6 0.028 0.031
1978 90.4 0.032 0.035
1979 89.1 0.035 0.040
1980 89.0 0.040 0.045
1981 88.1 0.043 0.049
1982 88.6 0.049 0.056
1983 87.6 0.055 0.062
1984 87.2 0.060 0.068
1985 83.2 0.062 0.075
1986 80.8 0.068 0.084
1987 78.4 0.072 0.092
1988 75.1 0.074 0.098
1989 73.2 0.075 0.102
1990 74.9 0.085 0.114
1991 75.7 0.100 0.132
1992 76.5 0.111 0.145
1993 76.8 0.116 0.152
1994 78.2 0.123 0.158


Note: Values are for Fiscal Year Ending March 31 of t+1, that is,
1994 in this table means March 31, 1995.


Source: Deposit Insurance Corporation of Japan, Annual Report, 1995.


(vi) The failure of two credit cooperatives, Tokyo Kyowa and Anzen Credit Cooperative, was handled by liquidating the two cooperatives and transferring a good part of remaining assets to a newly established bank, Tokyo Kyodo Bank, in March 1995. The decision of the demise of two cooperatives was announced in December 1994. However, public debates over this case arose partly because many loans were fraudulent and partly because the scheme was quite new. The new bank received an infusion of capital from the Bank of Japan. There are several distinct features of the sixth case. First, all "shareholders" of the two credit cooperatives were asked to forfeit their position in the institution. While many would regard this as normal, it represents a departure from previous cases in which the DIC or some other group compensated shareholders for their book value. Second, in addition to the [yen]40 billion provided by the DIC beginning March 20, 1995, the Bank of Japan and a group of private banks each provided [yen]20 billion of new equity funding. This represents a departure from the previous cases in which the DIC provided the funds to accomplish the merger or liquidation. DIC funding resources apparently were inadequate to fill the gap between the market-value assets and market-value liabilities. In addition, the Tokyo Metropolitan government - the direct supervisor of the two credit cooperatives - was asked to provide subsidized loans to an institution that would sell off the bad part of the assets. However, the Tokyo Metropolitan Congress had not approved funding for this expenditure as of September 1995.
TABLE 2


FDIC: Insurance Deposits and the Bank Insurance Fund


a: Percentage of Total Deposits Insured
b: Insurance Fund as Percent of Total Deposits
c: Insurance Fund as Percent of Insured Deposits


Year a b c


1971 61.3 0.78 1.27
1972 60.2 0.74 1.23
1973 60.7 0.73 1.21
1974 62.5 0.73 1.18
1975 65.0 0.77 1.18
1976 66.7 0.77 1.16
1977 65.9 0.76 1.15
1978 66.4 0.77 1.16
1979 65.9 0.80 1.21
1980 71.6 0.83 1.16
1981 70.2 0.87 1.24
1982 73.4 0.89 1.21
1983 75.0 0.91 1.22
1984 76.9 0.92 1.19
1985 76.1 0.91 1.19
1986 75.4 0.84 1.12
1987 75.3 0.83 1.10
1988 75.1 0.60 0.80
1989 76.0 0.54 0.70
1990 75.9 0.16 0.10
1991 77.7 -0.28 -0.36
1992 77.4 0.00 -0.01
1993 76.5 0.53 0.69
1994 77.0 0.89 1.15


Note: The Bank Insurance Fund insures deposits of banks and savings
banks.


Source: Federal Deposit Insurance Corporation 1994.


(vii) Due to the institution's small size, the failure of Yuai Credit Cooperatives and its being merged with Kanagawa Labor Bank in July 31, 1995, was a much less publicized case. The DIC provided [yen]2.8 billion in financial assistance to the Kanagawa Labor Bank.

(viii) Cosmo Credit Corporation collapsed in August 1995 as a classic run depleted reserves at the cooperatives, and the Tokyo Metropolitan Government ordered the suspension of business, except for paying out deposits. The bailout consists of funds from Sanwa Bank, Cosmo's largest creditor; several other banks; the National Federation of Credit Cooperatives; the Tokyo metropolitan government; and the DIC. Cosmo's remaining operations will be transferred to the Tokyo Kyodo Bank. The estimated cost of the loss was [yen]240 billion. The DIC is expected to contribute about [yen]110 billion when the scheme is finalized.

(ix) At the end of August 1995, the Ministry of Finance ordered the liquidation of the Hyogo Bank, which held about [yen]3,400 billion in deposits, and the Osaka Metropolitan government ordered the suspension of business to Kizu Credit Cooperative, which held about [yen]1,200 billion in deposits. Both institutions were experiencing deposit withdrawals as news of their financial position and of the demise of the other credit cooperatives spread. Hyogo will be reorganized into a new entity while Kizu will be liquidated. Kizu's operations presumably will be transferred to another institution.

The total cost to the DIC of dealing with the two most recent insolvencies is expected to reach about [yen]800 billion. This cost, in fact will deplete the DIC existing reserves of [yen]876 billion held at the end of March 1995 and before depletion for Cosmo. As a technical matter, as of September 1995, the DIC essentially had zero net worth. However, according to the law and guidelines related to DIC operations, DIC can borrow up to [yen]500 billion from the Bank of Japan with a short notice, and the ceiling of borrowing could be raised relatively easily.

(x) Osaka Credit Cooperatives failed in December 1995. The loss and financial assistance will be decided soon.

The DIC has had a turbulent record in its short history. The first 20 years were uneventful, and few regarded the DIC as very important in the deposit guarantee system, though a number of commentators mention the potential problem of a poorly funded deposit insurance agency in the context of financial liberalization (e.g., Cargill, 1985; Ueda and Ito, 1993). Since 1991, the DIC has become a focal point of discussion. The two most recent bailouts in late 1995 have rendered the DIC insolvent. The DIC most likely will be restructured and its reserves built up with higher deposit insurance premiums and public funding.

Vl. THE SAVINGS INSURANCE CORPORATION

The Agricultural and Fishery Cooperative Savings Insurance Corporation (AFCSIC) was established in September 1973 and was based on similar principles as the DIC; however, it is administered by the Ministry of Agriculture, Forestry and Fisheries and the Ministry of Finance. It insures the deposits of about 5,500 agricultural and fishery cooperatives and has the authority to pay off depositors of a failed institution or to assist the merger between an insolvent and a solvent institution. Membership is mandatory and, like the DIC, the AFCSIC has made no actual payments to depositors of a failed institution. However, it did assist a merger between the insolvent Kagoshima City Cooperative with the Tagami Agricultural Corporative in 1978.

The AFCSIC is much smaller than the DIC. As of March 1993, AFCSIC reserves were [yen]82 billion compared to [yen]696 billion in reserves held by the DIC. Thus, for all practical considerations, the DIC plays the major role in Japan's explicit system of deposit guarantees.

The AFCSIC also is grossly underfunded relative to deposits and to the potential amount of nonperforming loans held by insured institutions. At the end of fiscal year 1992, agricultural and fishery cooperatives held [yen]66,025 billion in deposits or [yen]13.6 billion per institution. The ratio of March 1993 reserves to 1992 deposits is 0.12 percent, a ratio slightly less than the DIC in 1993. Agricultural cooperatives have extended significant funds to the housing institutions (jusen). The Ministry of Finance in September 1995 indicated that the housing companies have [yen]8.4 trillion in nonperforming loans. Assuming a loss ratio of 60 percent, the housing loan companies in September 1994 held about [yen]5 trillion as unrecoverable losses. How much of this loss will be assumed by the agricultural cooperatives depends on how the [yen]5 trillion loss would be divided among shareholders. Banks and insurance companies and agricultural cooperatives provide about 40 percent of the credit cooperative funding. This is the sticking point in the current discussion. Ostrom (1995, p. 3) estimates that agricultural cooperatives would assume about [yen]1.4 trillion in losses. The AFCSIC had about [yen]100 billion reserve at the end of March 1995. Thus, if AFCSIC were to assume part of jusen losses attributable to the agricultural cooperatives, the AFCSIC would be insolvent.

VII. THE POSTAL SAVINGS SYSTEM

Postal savings are government guaranteed savings plans in which consumers deposit and withdraw funds at post offices. The banking community has long complained that post offices take private sector business opportunities by offering a slightly higher interest than do their banking counterparts and by offering unique products such as 10-year deposit certificates with progressive interest rates. (During the 1980s, the longest term for deposit certificates was three years. Only in September 1995 were banks allowed to offer certificates with maturities longer than five years - up to 10 years.) Because postal deposits are guaranteed by the government itself, the Postal Savings System, does not pay an insurance premium. As a result, the potential exists for disintermediation of bank deposits to the Postal Saving system either because of interest rate advantages or because of perceived problems with private depositories. The Ministry of Posts and Communications usually defend the system as the result of synergy scale economies with postal business.

The deposit taking activity of the postal system is a major component of Japan's financial system. Over 18,000 post offices accept transactions, savings, and time deposits as well as offering credit card services. The Japanese Postal Savings System is the largest financial institution in the world in terms of deposits accounting for slightly more than 30 percent of total household deposits outstanding, or [yen]30 trillion. In 1993, postal savings deposit flows are projected to account for 32.5 percent of the distribution of personal savings deposits in Japan, or $1.8 trillion dollars at an exchange rate of [yen]100 = $1.00.

Regulatory advantages provided to the Postal Savings System and the importance of postal receipts in the Fiscal Investments and Loans Program (FILP) help explain why the Postal Savings System remains such a prominent part of Japan's financial system despite the official effort to liberalize the flow of funds. The FILP provides funds to support the special and government agencies budgets and to a lesser extent some of the spending in the general account budget. The FILP plays a major role in public spending; in FY 1994, FILP equalled 65 percent of the general account.

The role of public intermediation in the financial system in Japan is far more extensive than that in the United States and has become increasingly controversial. The national government has three budgets: general account budget, special account budget, and government-agencies budget. (Ito, 1992, Chapter 6, provides an overview of the three budgets and the role played by the Postal Savings System in Japan's fiscal program; Ostrom, 1994, provides additional statistical information). The general account budget is similar in purpose and construction to the U.S. general budget in the sense that it records government revenues from taxes and fees on one side and spending on the other side. The other two budgets are a special feature of Japanese public spending and finance and are overlaid by the FILP.

The FILP obtains a significant portion of funds through the postal system, which collects funds from the household sector for three purposes: postage, savings, and life insurance. In FY 1992 actual spending, funds from the postal system saving accounts and insurance or Kanpo represented 40 percent of the sources of funds for FILE. In addition, another 38 percent were repayment of past FILP loans, which in turn represents past postal savings money. The proportions basically stay the same for the FY 1994 plan.

VIII. CONCLUDING COMMENTS

The bubble and its burst have revealed fundamental problems in Japan's system of deposit guarantees. At one end of the spectrum are the large city and regional banks that many regard as "too-big-to fail." It is unlikely that the Ministry of Finance or Bank of Japan would allow these institutions to fail since such a failure would pose a serious systemic risk beyond Japan. For example, Japanese banks might rapidly sell off dollar denominated securities in a scramble for liquidity. However, for all practical purposes, deposits of these institutions are implicitly guaranteed despite the DIC limit.

Of course, the "too-big-to fail" policy has at least as many problems in Japan as it has had in the United States and perhaps even more as the liberalization process continues. However, the other side would be a serious systemic risk. Opinions on how to deal with it are divided.

The Postal Savings System stands at the other end of the spectrum. Postal savings deposits are guaranteed by the full faith and credit of the Japanese government. Thus, large private bank deposits at one end of the spectrum and postal deposits at the other end, possess an implicit government deposit guarantee for all practical purposes. In between the two ends of the spectrum are a large number of local banks and a very large number of credit cooperatives whose guarantee status is less certain, as the above discussion of deposit guarantees suggests. These institutions also are most likely to be hard hit by liberalization of small deposits.

The Ministry of Finance's July 1995 announcement indicated that a direct pay off of depositors of insolvent institutions would not take place until the condition warrants and that such a condition would be facilitated within five years. This announcement is widely interpreted as meaning that the government has extended deposit guarantees to all deposits for the next five years.

In the long run, the bi-model structure of government deposit guarantees is potentially destabilizing, as large deposits beyond the formal ceiling of the DIC guarantees might flee to large institutions and as smaller deposits choose the convenience of postal saving.

In the short run, the administration of the deposit guarantee system has shown an unwillingness to learn from the policy errors that led to the collapse of the U.S. S&L industry, Federal Savings and Loan Insurance Corporation, and temporary insolvency of the Federal Deposit Insurance Corporation. Earlier assisted mergers did not impose discipline on shareholders. This was corrected in 1995. "Forbearance policy" has increased nonperforming loans and losses to the deposit insurance fund due to moral hazard which seems to be changing as evidenced by the Ministry of Finance's decision to close down the Hyogo Bank. The challenge of the future is determining how to discipline depositors by imposing losses on deposits without causing systemic risk.

ABBREVIATIONS

AFCSIC: Agricultural and Fishery Cooperative Savings Insurance Corporation DIC: Deposit Insurance Corporation FILP: Fiscal Investments and Loans Program

1. The increase by [yen]8 trillion occurs when one includes restructured loans with the interest rate lower than the original contract rate but higher than the official discount rate. For example, [yen]5.5 trillion loans from agricultural cooperatives to jusen (housing loans corporations) carries reduced interest rate of 4.5 percent. These are not included in [yen]40 trillion but are included in [yen]48 trillion. Some observers suggest that the actual amount of nonperforming loans is likely to be at least twice the amount officially admitted and the loss ratio much higher than 30 percent. The estimates are sensitive to how much land prices have fallen and to how much collateral values have declined. in mid-1995, some quoted [yen]100 trillion as nonperforming loans (Ostrom, 1995, p. 3).

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Thomas F. Cargill is Professor of Economics, University of Nevada, Reno; Michael M. Hutchison is Professor of Economics, University of California, Santa Cruz and Visiting Scholar, Federal Reserve Bank of San Francisco; Takatoshi Ito is Senior Advisor, Research Department, International Monetary Fund and Professor of Economics, Hitotsubashi University, Institute of Economic Research. This paper draws heavily from a chapter in a manuscript to be published by the MIT Press. An earlier version of the paper was presented at the Bank Structure and Competition Conference sponsored by the Federal Reserve Bank of Chicago, May 1995 and was published in the Federal Reserve Bank's proceedings of the conference. The earlier version also was presented at the Western Economic Association International 70th Annual Conference, San Diego, California, July 1995, in a session organized by George Kaufman, Loyola University, Chicago, Ill.
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Author:Cargill, Thomas F.; Hutchison, Michael M.; Ito, Takatoshi
Publication:Contemporary Economic Policy
Date:Jul 1, 1996
Words:6445
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