Japan's Banking Crisis, 1991-2005

2.1 Causes of the Banking Crisis: Bursting of the Bubble

One of the direct causes of the banking crisis in Japan was the bursting of the asset price bubble in the period from the late 1980s to the early 1990s. After the 1985 Plaza Accord, Japan pursued expansionary fiscal and monetary policies to counter fears of recession brought about by the sharp appreciation of the yen. At the same time, a strong yen created a confidence and optimism in the future of the Japanese economy. This belief—supported by abundant liquidity and self-fulfilling expectations of ever rising prices of stocks and land—led to asset price bubbles. Stock and land prices peaked in December 1989 and March 1991, respectively, as shown in Figure 1 [ PDF 47.1KB | 1 page ].

Against this background, there were basically three causes of the banking sector crisis in the 1990s. First, bank loans were overextended particularly in risky areas with inadequate supervision and regulation over banks during the bubble period. Specifically, loan portfolios were concentrated in property-related businesses such as construction, real estate, and nonbank financial services. As most of these loans were collateralized by land whose values plummeted after the bubble burst, and cash flows were inadequate to repay the loans, these became nonperforming. Table 1 [ PDF 56.1KB | 1 page ] shows how bank portfolios were concentrated in these businesses.

Second, banks were allowed to hold common stock on their balance sheet and had accumulated sizable unrealized capital gains, boosting their capital base. The bursting of the stock price bubble reduced these unrealized capital gains and eroded the value of capital reserves of many banks. The decline of their capital base damaged banks' ability to extend loans and take risks. In fact, the amount of bank loans outstanding declined from the peak in 1997 until the mid-2000s, despite government efforts to avoid a credit crunch, partly due to weak demand from industry for funds.

Third, the economic slowdown and price deflation in the 1990s also led to the growing levels of NPLs, especially in the late 1990s and the early 2000s. Figure 2 [ PDF 46.6KB | 1 page ] shows that the amount of outstanding bank NPLs reached a peak in March 2002. This phenomenon is important in the context of the recent large-scale recession worldwide. If macroeconomic policy is not well managed to support the real economy, then more loans will become nonperforming and NPL levels will increase. This could delay economic recovery as capital constrained banks tend to discourage credit growth. Hence, further capital enhancement would again be required.

2.2 Lost Years (1991–1997)

The initial policy adopted by the Ministry of Finance (MOF) was intended to protect ailing banks through regulatory forbearance and other forms of support, while gaining time for a hoped for recovery of economic growth and asset prices. The failure of Toho Sogo Bank in 1991 was the first bank failure in the postwar period in Japan. In 1994 and 1995, failures of small financial institutions accelerated.¹ In 1995–1996, the government injected JPY680 billion to deal with jusen, specialized, nonbank housing loan companies. This policy was unpopular politically, and the government was heavily criticized for bailing out the nonbank financial institutions. As nonbank mortgage finance companies, jusen were less strictly regulated, and thus more aggressive in their lending to real estate-related small businesses than larger commercial banks during the bubble period. Large commercial banks, constrained by stricter oversight, essentially financed jusen and often exercised influence over their business.

The unpopularity of jusen intervention discouraged the MOF from pursuing policies to use public funds to address bank balance sheet problems. The government did make efforts to contain the emerging difficulty in the banking sector without using public funds. In June 1996, the deposit insurance system was strengthened through a major amendment of the Deposit Insurance Law including a temporary suspension of limits on deposit protection—at first, until March 2001, then extended to 2002, and after another amendment in 2002, eventually until March 2005—(thereby introducing a blanket guarantee of bank deposits), and an increase in the insurance premium from 0.012% to 0.084% of total deposits outstanding. These efforts were mainly targeted at problems of credit cooperatives rather than for major banks.

Economic growth had slowed down sharply in 1992–1994 following the bursting of the asset price bubble. Growth began to resume in 1995–1997, but the adoption of tight fiscal policy and the outbreak of the Asian financial crisis sent the economy back to recession. This fueled the banking crisis in Japan, which became acute in late 1997, affecting large financial institutions and major banks. Stagnant economic conditions and falling asset prices intensified market pressures, leading to the 1997–1998 systemic banking crisis. The pressure exerted by the crisis forced the government to take much more decisive action than in the earlier years. In the fall of 1997, Yamaichi Securities, one of the four largest security houses, collapsed and a medium-sized one, Sanyo Securities, also failed. These security houses were not able to obtain short-term funding in the Japanese interbank market due to their heightened risks as judged by market participants. Hokkaido Takushoku Bank, a city bank, became unable to raise funds in the interbank market and had to announce its discontinuation of business operations in November 1997. Subsequently, the premium for offshore foreign-currency interbank loans extended to Japanese banks by foreign banks, called the “Japan premium”, surged from the fall of 1997 through the spring of 1999.²

2.3 Decisive Policy Action (1998–2001)

The government announced in December 1997 that up to JPY30 trillion of public funds would be made available to the Deposit Insurance Corporation of Japan (DICJ) by March 1998—comprised of JPY13 trillion to bolster bank balance sheets and JPY17 trillion to strengthen the deposit insurance system.³ Public funds were augmented to a total of JPY60 trillion—more than 12% of gross domestic product (GDP)—at DICJ for financial support for banks in October 1998.⁴

Public funds totaling JPY1.8 trillion were injected to the 21 major banks in March 1998 to help banks meet the required capital adequacy standards. Nevertheless, the government had to intervene in two major banks, the Long-Term Credit Bank of Japan (LTCB) and Nippon Credit Bank (NCB) which were temporarily nationalized in October and December 1998, respectively. Both banks had problems with mismanagement in their loan portfolio during the bubble period and thereafter. Their shares were acquired by DICJ with zero value and, after the restructuring of their assets, they were put on sale to the private sector. In order to induce buyers, the government guaranteed all assets of LTCB at the sales date for three years if they went bad (a “put” option), while NCB was sold without such support.⁵

It turned out that JPY1.8 trillion was not enough to fully recapitalize the ailing banking system. As a result, JPY7.5 trillion more of public funds were injected into 15 banks in March 1999. The second recapitalization operation encouraged private sector-driven capitalization and thus improved banks' capital adequacy ratios and addressed bank NPL problems. By the spring of 1999, banking sector stability was largely restored and the “Japan premium” narrowed substantially.

The authorities had long refused to recognize the full extent of bank NPLs. However, the 1997–1998 crisis forced the authorities to assess the solvency and soundness of the balance sheets of individual banks. The bank regulatory agency, together with the Bank of Japan, identified the total amount of NPLs of all banks to be JPY34 trillion, including JPY22 trillion for major banks, as of March 1999. However, these inspections were based solely on banks' own assessments of NPL classifications and levels, and doubts about the reliability of these figures were rampant.

The financial regulatory authority released an authorized inspection manual in 1999 and directed banks to adopt the stricter asset classification of NPLs in this manual. However, there were large discrepancies between inspectors' calculations of NPL levels and bank self-assessments. Table 2 [ PDF 52.3KB | 1 page ] shows that in 2000 and 2001, the government calculations indicated that banks underreported NPLs by 25% to 37%, and underestimated needed provisions and write-offs by 30% to 50%. This implied that at the time of bank recapitalization in 1998 and 1999, the exact scale of capital shortage was not accurately recognized by the authorities.

2.4 Recovery Phase (2002–2005)

In 2001 the Financial Services Agency (FSA), established in 2000,⁶ launched a special inspection of bank loans for the second half of fiscal year 2001. The inspection was limited to loans to large borrowers whose market indicators, such as share prices and credit ratings, had deteriorated rapidly, and where the exposure of each bank was high.

This process resulted in the large scale reclassification of loans to 149 companies; a quarter of the “normal” or “need attention” loans examined were reclassified to bad loans—“bankrupt” or “in danger of bankruptcy” loans. The increased regulatory pressure led to a dramatic change in loan classifications by the banks in 2002, with the value of NPLs of all banks rising by more than 25% from JPY33.6 trillion at fiscal year-end 2000 to JPY43.2 trillion at fiscal year-end 2001. The FSA conducted a second round of special inspections in 2003 that covered loans to 167 borrowers—of which 142 had been examined in the first round of special inspections in fiscal year 2001—at 11 major banks that totaled JPY14.4 trillion.

As a result of the stringent FSA inspection of bank loan quality, an enhanced and extensive policy package, Program for Financial Revival (PFR), was introduced in October 2002. PFR was intended to accelerate bank loan restructuring through a decisive three-pronged strategy:

• Reduce the amount of equities held by banks to a level equal to 100% of Tier-1 capital by September 2006.
• Strengthen the classifying of and provisioning for nonperforming loans through measures such as new inspections of major banks, harmonization of loan classification for large borrowers across banks, and disclosure of the gap between major banks' self-assessment of problem loans and FSA assessments.
• Remove 50% of banks' new NPLs within one year and 80% within two years, with a target of halving the ratio of major banks' NPLs by March 2005 from the 8.4% March 2002 level. (No quantitative target was set for regional banks.)

As a result, loan classification and loan loss provisioning were strengthened, beginning with the fiscal year 2003 measures to improve the classification of loans to large businesses.

As a part of comprehensive efforts to revitalize the banking system and the economy, the government established a new asset management company, the Industrial Revitalization Corporation of Japan (IRCJ) in April 2003. IRCJ focused on higher quality NPLs—classified as those that “need special attention”—extended to larger firms than did the then existing Resolution and Collection Corporation (RCC), a government-owned asset management company which bought assets from failed banks.⁷ The objective of IRCJ was designed to promote the restructuring of relatively large and troubled, but viable, firms by purchasing their loans from secondary banks, leaving the main bank and IRCJ as the only major creditors. IRCJ was expected to promote “structural reform” of the Japanese economy by enabling troubled large firms to revive.

Another policy to restore bank balance sheets to health, introduced as part of PFR, was to force all banks to reduce their holdings of equities to a level equal to 100% of its Tier-1 capital by September 2006. For the enforcement of this policy, the government set up a new institution, Banks' Shareholdings Purchase Corporation (BSPC), in January 2002 to buy the stocks held by banks. BSPC purchased about JPY1.6 trillion of stocks from banks by 2006. The Bank of Japan also purchased stocks from banks, as part of “quantitative easing” under the zero interest rate policy, and the total amount bought by the Bank of Japan reached approximately JPY2 trillion between 2002 and 2004.

With the mix of the policy measures to resolve the banking sector problems, the NPL ratio for the major banks went down to 2.9% by March 2005, at which point the government announced that the prolonged NPL problems had ended. Japan's economy returned to a full-fledged recovery path supported by global economic expansion starting in 2004.

2.5 Costs of Resolving the Banking Crisis

Japanese banks incurred cumulative losses—inclusive of net costs of provisions for loans and direct write-offs—of some JPY96 trillion between fiscal year 1992 and fiscal year 2004. It was only after 2003 that the functioning of the banking system began to improve.

The authorities deployed a total of JPY47.1 trillion into the banking system through DICJ, composed of monetary grants (JPY18.9 trillion), capital injections (JPY12.4 trillion), asset purchases (JPY9.8 trillion), and other measures (JPY6.0 trillion). Of the public funds deployed, only JPY25.1 trillion was recovered, or approximately 50% of the total spent, as of September 2008 (see Table 3 [ PDF 48.2KB | 1 page ]). Monetary grants were made for the orderly closure of failed banks, which included the costs of blanket deposit guarantees. Of the total amount of monetary grants (JPY18.9 trillion), JPY10.4 trillion was not recovered and hence was paid by taxpayers, with the remainder to be covered by bank premiums paid to DICJ. Most of the costs associated with asset purchases and capital injections were recovered by 2008. Three megabanks, Mitsubishi UFJ Financial Group (FG), Mizuho FG, and Sumitomo Mitsui FG, had repaid all of public funds injected into them for recapitalization by 2006. The authorities incurred other costs resulting from the asset price guarantee that was provided to the purchasers of failed institutions.

The overall costs to the economy were not limited to such unrecovered public funds. The opportunity costs to the Japanese economy were huge due to the decade long economic stagnation. The cumulative output that was lost in the three years after the outbreak of the 1997 banking crisis could be as large as 18% of GDP (Laeven and Valencia, 2008). Furthermore, trust in the banking sector was severely damaged. The diminishment of the established Japanese banking network and business opportunities abroad, particularly in Asia, in the precrisis period was equally important. Positive results from Japan's banking crisis include the complete revamping of the supervisory and regulatory structure for the finance sector, establishing the FSA as a more credible, independent, and integrated agency, and creating a healthier banking system in Japan.

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