Relevance of Japan's Lesson to the US Financial Crisis

4.1 Similarities and Differences between the US and Japanese Crises

There are remarkable similarities between Japan's banking crisis in the 1990s and the 2007–2009 financial crisis in the US, although the ways the two crises developed are significantly different. The rapid evolution of the US financial crisis sharply contrasts with the lingering Japanese NPL problem and its resolution process. Policies were deployed in a similar order in both crises, but the period over which they were deployed differed considerably. Capital injections were the first step, followed by asset purchases using public funds, and then a strict examination of bank assets or stress-testing.

In the US case, although the Board of Governors of the Federal Reserve System introduced various measures to support market liquidity during 2007 and 2008, the first important step in using public funds was taken in October 2008—a package of US$700 billion aimed at restructuring troubled institutions, of which US$250 billion were set aside for capital injections. All major financial institutions were involved in this recapitalization program.

The collapse of Lehman Brothers in September 2008 highlighted the uncertainty that prevailed in the financial markets. In addition to Lehman's collapse, there were other financial shocks, including the bailouts of two government-sponsored enterprises (Fannie Mae and Freddie Mac) and American International Group, and upheavals at Merrill Lynch among others. The impact was not confined to the US markets; it spread to major financial markets globally.

Similarities in the development of the crises include: (1) the formation and bursting of an asset price bubble, which caused debt levels to expand too much and then subsequently drop under pressure for deleveraging; (2) extensive damage to the quality of bank assets caused by a collapse of real estate prices, and (3) failure of large financial institutions—Yamaichi and two long-term credit banks in Japan, and Lehman Brothers and other highly-leveraged institutions in the US.

The two crises are quite different in some aspects as summarized in Table 5 [ PDF 51.6KB | 1 page ]. First, in the Japanese case, bank loans—particularly loans to the corporate sector that were backed by real estate collateral—were the major problem in the financial sector, while the share price collapse also damaged bank balance sheets. In the recent US crisis, securitization played a critical role in amplifying the crisis among a wide range of global financial institutions. In the US deleveraging is required for households, whereas in Japan this was required for firms.

Second, the causes of the failures of financial institutions are different. In the US, in addition to investments in “toxic assets,” failed institutions turned out to be extremely vulnerable due to their heavy reliance on wholesale funding. In this sense liquidity and counterparty risk played a critical role in destabilizing the short-term funding market. In contrast, Japanese financial institutions had fundamental problems in their business strategies and asset management, and liquidity shortages triggered their failures. Yamaichi Securities committed misconduct in the management of their clients' assets, and the two failed long-term credit banks were engaged in excessive lending activities not only to the domestic real estate sector but to overseas resort projects, rendering them unable to fund in the wholesale market.

Third, there was a difference in accounting practices in the two countries. Japanese accounting and disclosure rules during its crisis period resulted in financial statements that were slow to reflect economic reality and incomplete in doing so. In the ongoing US crisis, in contrast, financial statements are released quarterly and are based on mark-to-market valuations. Although this practice has the advantage of reducing the uncertainty involved in the valuation of assets and financial health of banks, it tends to reflect market overreaction under extreme stress. When no reliable data are available as a result of a severe liquidity crunch, the market often temporarily misprices or excessively undervalues assets.

4.2 Deepening of the US Financial Crisis

In May 2009, the US Federal Reserve released the results of the Supervisory Capital Assessment Program (SCAP) regarding the capital held by 19 largest US bank holding companies (BHC). The targets set by the supervisors were a Tier-1 risk-based ratio in excess of 6% at year-end 2010 and a Tier-1 common capital risk-based ratio in excess of 4% at year-end 2010. Any BHC needing to augment its capital buffer would be required to develop a detailed capital plan to be approved by its primary supervisor over the next 30 days and implement that plan in the next six months.

The results of the SCAP suggested that if the economy were to track a more adverse scenario, losses at the 19 BHCs during 2009 and 2010 could be US$600 billion. Out of this, US$445 billion would come from losses on accrual loan portfolios, particularly from residential mortgages and other consumer-related loans. After taking account of these losses, revenues and requirements for reserve building, in the aggregate, the 10 BHCs out of the 19 examined would have to add US$185 billion to their capital base in order to reach the target SCAP capital ratios at the end of 2010. The vast majority of this US$185 billion would come from a shortfall in Tier-1 common capital.¹¹

A number of BHCs have either completed, or contracted for, asset sales or restructured existing capital instruments since the end of 2008, and thus, additional capital needed to meet the SCAP targets was estimated to be US$75 billion. This figure may be the minimum since many economists including the International Monetary Fund (IMF) indicate that a larger amount of capital is required to restore the US banks' capital base.

As of April 2009, the IMF suggested that the total amount of asset write-downs could reach around US$4 trillion globally (IMF 2009), about two-thirds of which would be incurred by banks. The amounts of capital needed to reduce leverage ratios to 17 and 25 were estimated at US$275 and US$500 billion, respectively, for US banks depending on the scenario.¹² A year later, Global Financial Stability Report of the IMF stated that capital ratios of aggregate banking systems in the US have improved (IMF 2010). However, some segments of banking systems such as regional banks and government-sponsored enterprises remain poorly capitalized and face significant downside risks.

Depending on the recovery of the US real economy, there is still a possibility that the US banking system remains undercapitalized, with numerous insolvent banks. Clearly a more robust banking system requires more capital and robust loan loss reserves added to the capital cushion. Until impaired assets are disposed of and removed from bank balance sheets and the banking system is adequately recapitalized, credit flows are likely to be restricted.

4.3 Measures Ahead

Based on the SCAP, banks are moving to raise capital and/or repay the public funds injected, depending on the individual result of the stress test. At present, there are several concerns that merit careful consideration.

First, the impact of the adverse feedback loop between the financial sector and the real economy could be underestimated, which could add to the severity of the crisis. Although the worst is over in the US economy, with the large household debt being reduced through higher savings, given that housing prices are still not recovering, and unemployment rates are expected to remain high, there is a significant risk that bank NPLs will continue to expand. This would make it difficult for banks to expand credit flows to households and corporations at a healthy pace.

Second, with the much improved accounting and disclosure standards compared with those of Japan in the 1990s, authorities are in a better position to address this problem now. The composition of NPLs at US and European financial institutions is now shifting to the traditional loans on the banking book such as lending to commercial real estate. Effective measures to clean up banks' balance sheets still have to be implemented.

The private-public investment program (PPIP) under the second phase of TARP has been criticized in popular press by reputable analysts, including Paul Krugman, Jeffrey Sachs, and Joseph Stiglitz. One of the reputed problems with PPIP is that banks with “toxic assets” may not have sufficient incentives to sell them to investors. The institutions do not have to accept the bid, and they will do so only when the bid is higher than what they think the assets are worth. So the result is that many banks may not wish to remove “toxic assets” from their balance sheets. If banks are not willing to sell such assets, the government may have to step in by forcing banks to reduce troubled assets to a certain level within a given time period, as Japan's Program for Financial Revival did in October 2002. PPIP did not work effectively and, as a result, was effectively abandoned.

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