Conclusion

The Japanese government failed to tackle the banking sector problem in the 1990s in a prompt and decisive manner because the crisis was slow to develop, its severity was underestimated, growth expectations were too optimistic, no major domestic and external pressure existed, and a legal framework for resolving distressed banks was lacking.

Following the 1997–1998 systemic crisis, the authorities became much more aggressive in addressing problems. They established a comprehensive framework for bank resolution, which involved the following measures: (1) public capitalization of weak but viable banks; (2) temporary nationalization of non-viable banks; (3) tighter loan classification through stringent “special inspections”, (4) aggressive NPL reduction through a regulatory program; and (5) creating new institutions for corporate debt restructuring.

Acknowledging the extent and depth of the bank balance sheet problem, as a source of potential loan losses, is the first step toward resolving a banking crisis. Once the government estimates the size of the crisis, prompt action to recapitalize the banks that are viable but under-capitalized is an effective measure to restore market confidence and stabilize the banking system. The next step is to remove impaired assets from bank balance sheets. This often requires an institution, like a government-funded asset management company, to purchase such troubled assets. Therefore, recapitalization and asset purchases can be mutually complementary measures to restore a resilient capital base and banking sector health. A well-designed policy combination could minimize taxpayers' costs.

To resolve the financial crisis, the US government needs to induce banks to remove NPLs from their balance sheets. To do so may require the government to devise new, adequate incentives to banks—or to resort to regulatory measures, as was done in Japan in 2002—so that banks dispose of NPLs. Otherwise it would be difficult to restore healthy flows of credit to households and firms.

Causal links can work both ways; a financial crisis damages the real economy, and the worsening of the real economy can also create new NPLs and may eventually deplete bank capital. Essentially, deterioration of the real economy can lead to another round of financial crisis, which can further damage the real economy. If the authorities do not address the banking sector problem promptly, then the crisis may prolong, and a full-fledged economic recovery will be significantly delayed. This could result in a “lost decade” for the economy.

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