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Japan's Past Recession Provides a Cautionary Tale

by Michael W. Stocker and Christopher J. Keller
The National Law Journal |
What few realize is that these events took place in Japan, more than a decade ago, and that the resolution of the Japanese crisis has important implications for reform in this country.

The list of woes is all too familiar: In the midst of a financial crisis erupting from the deflation of a vast real estate bubble, bankers and regulators quarrel over how best to rein in the excesses of the financial markets. Industry supporters call for government bailouts of declining institutions and prophesy that mark-to-market accounting rules will result in calamitous write-downs of assets.

What few realize is that these events took place in Japan, more than a decade ago - and that the resolution of the Japanese crisis has important implications for reform in this country.

The Japanese financial crisis of the 1990s had its birth in a real estate bubble fueled by easy money, the lack of adequate regulatory oversight and inadequate risk management by banks.

Japan's central bank, the Bank of Japan, cut interest rates from 9% in 1980 to 4.5% by 1986. Bank of Japan,

In 1987, this rate was reduced even further to 2.5% and was kept there for three years.

As interest rates reached historic lows, Japanese banks gave cheap and easy credit to companies and consumers. As a result, a fever of real estate speculation took hold of the Japanese public.

This frenzy was amplified by a series of measures adopted by the Japanese government in the 1980s aimed at deregulating the markets. These changes, including a relaxation of loan ceilings, significantly strengthened the ability of large corporations to borrow directly from the market rather than from other banks. This left the banks with a surplus of cash, which they loaned to an increasingly large circle of risky borrowers.

At the time, Japanese banks' risk-management practices relied on the notion that high economic growth would continue indefinitely. Commercial banks had not developed a credit culture allowing the accurate assessment and pricing of credit risk that is crucial for sound banking.

"Times New Roman">The burst bubble

When the asset bubble burst in the early 1990s, Japanese banks, bearing huge loads of debt, had little ability to repay obligations due to the decline in collateral value. This created huge numbers of nonperforming loans. The erosion of the capital base of commercial banks compelled the banks to call in loans to remain in conformity with minimum capital requirements.

By 2000, commercial land values in the six major metropolitan areas had fallen by 80% from the peak level in 1991. Dick K. Nanto, CRS Report for Congress, "The Financial Crisis: Lessons from Japan," Sept. 29, 2008.

The overexposed and the undercapitalized Japanese financial services sector was put into a tailspin. By August 2001, Japan's Nikkei stock market average had dropped by more than two-thirds from its all-time high in 1989.

Despite this massive decline in asset values, Japanese banks were slow to reveal the losses they carried on their books. This subterfuge was easy because, at the time, Japan had few regulations regarding the disclosure of nonperforming loans. The banks hoped that if they hid disclosure of these losses long enough, they could simply wait out the decline in real estate values and avoid revealing losses to investors.

Japanese industry leaders also warned the Japanese government not to attempt reform by inserting itself into the internal affairs of banks, insisting that regulators should have no role in telling banks how to run their businesses. Requiring that banks expose the full extent of their losses during an economic downturn, they argued, would only hasten their decline.

As a result, the Japanese government's first efforts to deal with the crisis were extremely conservative. The government used ultralow interest rates and infusions of capital in the hopes that asset and stock prices would recover and banks' balance sheets would eventually improve. Moreover, the government permitted banks to value assets using their own standards without government supervision - leaving to the imagination what these assets would fetch on an actual market.

This approach failed to revive confidence in Japan's financial system. With their balance sheets still plagued with bad loans, banks could not lend money for new investment that might galvanize economic activity. Moreover, because the true extent of losses had yet to be revealed, the banks' counterparties lacked confidence in their creditworthiness. The lack of transparency about the true extent of losses invited assumptions that the reality was far worse than the banks let on.

Despite the continual infusions of cash to banks, the financial crisis steadily grew more serious and, in 1997, Japan's banking sector experienced a systemic crisis with a string of major bank failures and a credit crunch. Two major banks, the Long-Term Credit Bank of Japan and the Industrial Bank of Japan, went bankrupt and had to be nationalized.

The government resorted to still more infusions of cash. By October 1998, the Japanese government had invested $495 billion, or 12% of the nation's gross domestic product (GDP), for the financial support of banks. This enormous investment did nothing to restore market confidence and stock prices continued to slide. Economic growth ground to a halt.

"Times New Roman">Reform comes late

Effective reform did not come until late 2002, when Heizo Takenaka, the then-economic minister and the head of the newly formed Financial Services Agency (FSA), spearheaded an effort to reform Japan's financial regulatory system. Displacing many of the functions of the beleaguered ministry of finance, the FSA was a hybrid agency given multiple jurisdictions, including banks, securities houses and insurance companies.

In October 2002, Takenaka announced a drastic plan to upend the existing regulatory system.

The plan focused on stricter disclosure requirements, more aggressive transparency rules and increased government oversight of banking operations. In particular, his plan called for the FSA to perform its own inspection of the loans on banks' books and to ensure that underperforming loans were accurately valued. At long last the capital markets and the investing public would know the true extent of each institution's exposure to loss.

If banks were found to be undercapitalized under the more rigorous standards, they were forced to accept a public-fund capital infusion with stringent conditions attached. Banks accepting capital infusions had to submit comprehensive business rebuilding plans to the government. If a bank failed to achieve its plan goals, the government could oust management and take over the bank.

Takenaka's reform met vehement political and institutional resistance. Fearing closer government oversight of their affairs, bankers protested that hasty implementation of the plan could damage the economy and demanded a watering down of the regulatory overhaul. "Too Weak to Work?" The Economist, Oct. 30, 2002.

Some politicians also vociferously attacked the reforms. They feared that directly tackling the problem of overvalued assets could mean bankruptcies for a number of large corporations, which, in turn, would mean erosion of their political and financial support.

These stakeholders were anxious for good reason. When the FSA pressed forward in implementing a full scale on-site examination of all major banks, it concluded that they all had significantly understated their nonperforming loans. FSA forced them to write off these bad loans and clean up their balance sheets. As a result, according to the International Monetary Fund, by 2005 Japanese banks were forced to write off about $810 billion, approximately 19% of the nation's GDP. Takeo Hoshi, "Resolving Japan's Banking Crisis," seminar presentation, March 19, 2009, at

Despite the chorus of protest from the banking industry and its allies, the Takenaka plan's requirement of increased transparency for bad assets proved to be precisely what was needed to restore market confidence. Finally, bankers and investors were convinced they had a more accurate picture of risk and knew which institutions had little risk of sudden failure. With the newly revived financial system, the Japanese economy finally started to grow again.

Although Japan has been hit hard by a recent decline in exports, Takenaka's plan, shaped by the country's bitter experience in the 1990s, has largely spared the country's financial system from the effects of the current global crisis.

The unfolding catastrophe in the U.S. financial services sector bears a resemblance to Japan's crisis of the 1990s. Prior to both crises, real estate and stock prices rose to unsustainable levels and irresponsible lending proliferated on the assumption that prices would continue to increase. Disasters in both countries were precipitated when housing prices began to decline, eventually depressing the values of huge amounts of assets held by financial institutions. These institutions responded by hiding these declines as long as possible by inflating asset values.

When bank losses became too great to hide and the crises spilled over into the national economies, public intervention by governments and central banks became necessary. Japan's efforts to resolve these problems can provide valuable guidance to American politicians and regulators. Thus far, many of Japan's lessons seem to have been neglected.

"Times New Roman">Problems at home

In an effort to shore up the rapidly weakening financial system, U.S. authorities have already provided huge amounts of liquidity and public capital, investing hundreds of billions to bail out insolvent banks. Critics of the infusion say that, as in Japan, these injections of capital have had little effect in restoring faith in the financial sector.

Moreover, Ben Bernanke, the chairman of the Federal Reserve, recently endorsed the idea that, during the current economic downturn, banks should be permitted to avail themselves of more flexible valuation rules to avoid booking as many losses. Edmund Andrews, "Bernanke Says Financial Rules Need Overhaul," N.Y. Times, March 11, 2009.

At the behest of bankers, two members of Congress, representatives Ed Perlmutter, D-Colo., and Frank Lucas, R-Okla., have proposed legislation that would create a new body with the power to suspend accounting rules for banks.

Moreover, on April 2, the Financial Accounting Standards Board approved new accounting rules that significantly weaken mark-to-market requirements, giving financial institutions more latitude in reporting asset losses.

While proponents of such actions argue that they will provide the flexibility necessary to avoid further undermining market confidence in the solvency of banks, opponents say that such proposals will only add fuel to our current troubles. As Japan's experience illustrates, while providing liquidity is critical to stabilizing the financial system, propping up insolvent banks by using public capital without requiring the revelation of the full extent of losses will not restore confidence. Market participants will still be left to guess the true extent of banks' exposure to risk, stifling investment.

Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, recently highlighted the concern of those advocating broader reforms in noting that "we have been slow to face up to the fundamental problems in our financial system and reluctant to take decisive action with respect to failing institutions . . . . We have been quick to provide liquidity and public capital, but we have not defined a consistent plan and not addressed the basic shortcomings and, in some cases, the insolvent position of these institutions." Thomas Hoenig, "Too Big Has Failed," speech, March 6, 2009 at

Indeed, if the Japanese experience provides any lesson, it is that confidence can return only when the financial markets and its participants have an accurate picture of the losses carried by banks.

Such complete disclosures have still not happened in the United States. As recently pointed out by former SEC Chief Accountant Lynn Turner, huge losses carried on many institutions' books have yet to be revealed. While a 2008 International Monetary Fund study suggested that losses on portfolios with exposure to housing loans could reach $1.6 trillion, by November 30, 2008, only $966 billion have been actually written down. Lynn Turner, comments at future of financial services regulation symposium, Dec. 12, 2008, Waldorf Astoria, New York.

In the wake of the catastrophe of the past two years, there can be little doubt of the popular and political appetite for reform of the financial services sector in the United States. However, in looking for solutions regulators would be wise to learn from the hard-won experience of Japan.