KWR International Advisor #11 November 2001

Addressing the Japanese Non-performing Loans Problem:
Toward Reestablishing the Principles of Capitalism in Japan

By Keiichiro Kobayashi, PhD, Research Institute of Economy, Trade and Industry (RIETI), Tokyo

When financial crises occur, the short-term goal is to minimize the risk of additional losses to restore the credibility of the financial system. At the same time, efforts must be made to advance toward the long-term goal of recovering sustainable growth through structural adjustments in the industrial sector.

In regard to present concerns over non-performing loans (NPLs) in Japan, there is confusion over the ability of the banks and the Financial Services Agency (FSA) to conduct asset reassessments. There is a pervasive suspicion that these asset evaluations are overly optimistic and do not reflect reality. To recover the credibility of Japan’s financial system, it will be necessary for banks and the FSA to conduct assessments based on criteria that would be considered excessive in ordinary times.

One of the reasons for this suspicion lies in the view that under the current assessment criteria there is room for discretionary decisions. For example, some corporations are alleged to "negotiate with banks to get a good asset rating." As long as assessments can be made through these "negotiations," it will be impossible for third parties to believe in the credibility of the assessments conducted by banks.

To maintain credibility during times of crisis, there is a need to restrict the criteria used for asset assessments to strictly numerical criteria.

For example, one method would be that for any major loans in amounts equivalent to 1% or more of a bank’s total credit, assessment criteria would be established as a ratio of outstanding debt to the current cash flow of the project concerned. Doing so would help restore credibility because the assessments would not be influenced by the consideration of uncertain and discretionary factors.

Some argue that excessive provision of reserves will have a negative impact on the profits paid out to the shareholders of banks. Although an excessive provision of reserves may reduce the dividend level paid out in a certain year, if the reserves are excessive, it will translate into greater profits in coming years from assets that are already backed by reserves. This will ensure a higher dividend yield in future years. A thorough provision of reserves, even in excessive amounts for the interim period, will have no negative impact on the long-term dividends paid to shareholders. One more issue that must be considered is the need to establish accounting principles that reflect this approach.

There is a possibility, however, that a bank may fall into insolvency if it provides for sufficient reserves. In this case, the only option would be to use steps, such as bankruptcy procedures, for the bank. Public funds would then have to be used as the source for the reserves. Consequently, if the reserves provided are too large, there is the risk that it will result in a temporary increase in the burden to be borne by the taxpayers. However, if a system were created where profit that is generated ex post facto from assets backed by excessive reserves reverts to taxpayers, the taxpayer burden would also be adjusted at that time.

To restore credibility in the economic system, a hands-on approach to asset evaluation based on strict assessment criteria must be implemented. It will need to determine the necessary amount of reserves that are required, and make the necessary provisions for these additional funds. This is necessary as a stage just prior to a final settlement through measures such as an appropriation of collateral provided by debtors and the initiation of bankruptcy procedures targeting debtor corporations. In other words, if the only steps taken involve the conducting of a strict asset assessment and an increase to sufficient levels of reserves, then it is natural that the market will expect that one or two years should be sufficient to resolve Japan’s NPL problem.

Otherwise, as the FSA recently pointed out, it may take more than seven years to complete final settlements involving the rebuilding and liquidation of debtors.

On the other hand, a strict assessment of assets and the provision of sufficient reserves can restore the credibility of Japan’s financial system. In no way does requiring banks to provide sufficient reserves over the next one or two years amount to excessive interference in market mechanisms. In fact requiring sufficient reserves will helpt to strengthen and restore confidence in market mechanisms.

After implementing strict asset assessments and providing for sufficient reserves to dispose of necessary losses, the ultimate disposal of the non-performing assets (NPAs) or NPLs that are backed by such reserves can be left to the discretion of the banks involved.

In this case, however, an adjustment mechanism must be created which, over the long-term, can realize the capital gains and profits that will result from the disposal of non-performing assets backed by the reserves. These can then be returned to the creditors and taxpayers who incurred the losses.

Towards this end, it would be effective to implement something along the lines of debt-equity swaps. In exchange for absorbing the loss that will accrue from the provision of reserves for NPAs, former creditors of those assets would receive equity rights to future profits that are accrued.

The debt-equity swap is an effective method of ex post facto adjustment, because making efficient use of NPAs that are backed by sufficient reserves and generating profits will benefit former creditors and taxpayers since those gains are returned to them as dividends on their equity rights.

After establishing a mechanism to return profits generated from NPAs backed by reserves, the question will be how to restructure or liquidate corporations for which reserves have been provided.

Items included in the Advance Reform Program, such as enhancing the function of the Resolution and Collection Corporation (RCC) and establishing a quasi-governmental investment fund to support corporate restructuring, are beneficial in rebuilding and liquidating corporations for which reserves have been already provided.

Of foremost importance, however, are the implementation of strict asset assessments and the provision of sufficient reserves.

Some may argue that disposal through the provision of excessive reserves will result in a deflationary spiral, and that compulsory provision of excessive reserves runs counter to the principles of capitalism.

But countering a deflationary spiral is the task of the Government and the Bank of Japan and concerns about deflation do not justify inadequately small provision of reserves by private-sector banks and others. During the Great Depression, the U.S. swiftly implemented a sweeping disposal of NPLs in the middle of a severe deflationary current. As a result, the credibility of the financial system was restored.

Ordinarily, if the credibility of a bank or a corporation is questioned, sufficient reserves are provided to restore that credibility. If not, it is normal for the bank or corporation to go bankrupt quickly.

This practice is not yet prevalent in Japan. The necessary capitalist principles were distorted by a culture in which people regarded banks and corporations as "virtual village collectives," and were therefore not criticized.

Indeed, it is part and parcel of the very principle of capitalism to voice criticism towards the management of banks and corporations that are performing poorly. In addition, taxpayers, who are in fact the shareholders of banks that receive public funds, need to exercise oversight regarding the way that such banks are managed. The disposal of NPLs is a necessary process for reestablishing the principles of capitalism in Japan.

After receiving a Masters Degree in Engineering from the University of Tokyo, Dr. Kobayashi studied at the University of Chicago, where he was awarded a Doctorate in Economics. He assumed his current position as a fellow at RIETI in April 2001.

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Keiichiro Kobayashi, Jonathan Lemco, Jonathan Hopfner, Darin Feldman, Uwe Bott