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Case study of the banking crisis - Japan's "Lost Decade"
Case study or template? My money is on the latter.

If Japanese bankers succeeded in fleecing their nation's treasury and future, why not the US and Europe?

Quote:Lessons From Japan’s Lost Decade

By Nikhilesh Bhattacharyya in Sydney
November 26, 2008

At the close of the 1980s, a collapse in house and stock prices crippled Japan's financial sector, leaving banks weighed down with nonperforming loans.
Attempts to restore the financial sector's health failed and a decade of stagnant growth ensued.
Facing a similar situation, U.S. authorities are shaping their policy response based on Japan's painful experience.
Similar to the recent experience of the U.S., Japan witnessed an enormous bubble in house and stock prices in the late 1980s. Following the bubble's bursting, Japan's banks were left with a large array of bad loans on their balance sheets, effectively crippling their ability to lend and dragging on the real economy for years. Despite massive government spending and interest rates effectively at 0%, the Japanese economy remained moribund; the financial system failed to function adequately and economic growth lagged for a decade.

Many wonder if the U.S. faces something similar to Japan's lost decade, or if a quick turnaround will follow the current recession. Although the future is unknowable, it appears aggressive U.S. actions have the potential to avert a Japanese-style scenario.

Japan’s lost decade
Japan’s credit meltdown began with the bursting of twin asset bubbles. Soaring house and stock prices, combined with financial liberalisation, had encouraged risky lending by the country's financial institutions. Banks outsourced their credit checking to monitoring agencies that reported directly to banks’ sales departments, who had aggressive targets for approving loans. With asset prices booming and credit growth soaring, lax regulation, along with fierce competition amongst financial institutions, led to loans being made against expectations of asset appreciation rather than cash flow. During Japan's bubble years, banks were writing mortgages with elevated loan-to-value ratios—just as during the U.S. crisis. Lending to business was also lax, with some companies able to use stock as collateral to tap bank loans. As house and share prices fell, many loans went delinquent.

To cope with the growing volume of nonperforming assets on their balance sheet, banks issued debt to raise capital and made even riskier loans to try and protect their shrinking margins. Regulators failed to provide discipline, out of fear that some major financial institutions might suddenly collapse. This caused a mild slowdown in credit growth rather than a sharp stop, as banks essentially swept their nonperforming loans under a rug.

What were policymakers doing?

The Bank of Japan and financial regulators were slow to react to the unfolding crisis. Blanket deposit insurance, coupled with a failure to punish poor performers, allowed the spread of so-called 'zombie banks'—institutions that did not go bankrupt, thanks to government guarantees, but were unable to lend because their balance sheets were crowded with nonperforming loans. With many Japanese wary of banks in general, and healthy commercial banks on the same footing as unhealthy ones because of government concerns about a systemic collapse, funds migrated away from retail banks.

A beneficiary of the retail banking sector's malaise was Japan's Postal Services Agency, which took deposits but did no lending. Unlike banks, the postal service was favoured by regulatory standards and enjoyed special treatment from government; while not having to pay deposit insurance, it had an explicit government guarantee, as it was publicly owned. The movement of funds to the postal service put further pressure on credit growth, constraining firms' access to credit and limiting their expansion plans.

Deposit Growth, % change
Retail Banks Postal Savings Agency
1991 -4.80% 14.20%
1992 -6.00% 9.30%
1993 1.30% 7.90%
1994 1.90% 7.70%
1995 3% 8.00%
1996 0% 5.40%
1997 2.90% 7.00%
Source: Bank of Japan
To try to stimulate credit growth, the Bank of Japan cut rates, but very gradually: It took over a decade to get the policy rate to 0%, from 6% in June 1991. Admittedly, it is questionable whether more aggressive moves would have stimulated credit growth, since retail banks struggled to attract deposits during the lost decade, limiting their ability to expand lending. In addition, demand for new loans was hurt by a long period of deflation, which pushed up real interest rates, hurting borrowers.

Just as it took time for the Bank of Japan to move interest rates down, regulatory and fiscal reforms were also tardy; not until 1998 was a comprehensive policy response to the banking crisis proposed. After years of debate over the merit of using public funds to bail out banks, Japan’s parliament passed a massive bank rescue package in October 1998. The package involved ¥60 trillion (equivalent to 12% of GDP at the time) and set aside funds for three major purposes. Nearly half the funds were used to recapitalise banks deemed weak but solvent, while the rest of the package was for the liquidation or nationalisation of insolvent banks and full deposit protection for account holders in these institutions.

Unfortunately, the spending package approved by parliament did not lead to recovery for the banking system. Total spending amounted to only around ¥10 trillion, with most of that being used to prop up ailing institutions rather than to eliminate the zombie banks. Apart from insufficient spending on recapitalisation, the method—which involved attempting to buy bad assets (as was initially proposed for the U.S. under the Troubled Asset Relief Program)—did not identify the problem of insufficient capital and was not aimed at closing insolvent banks.

The lost decade in retrospect

In hindsight, the deposit guarantee and the favourable treatment of the Postal Service Agency were major mistakes. With deposit holders' accounts fully insured by the government, deposit funds were not efficiently allocated towards healthy banks. Institutions with low profitability and poor risk-management structures clung to life—while the non-lending postal service increased its share of deposits at the expense of solvent lending institutions—leading to financial sector malaise that has not completely disappeared.

The financial system’s ill health produced a decade of slow growth and fundamental problems that linger today. Many wonder whether the U.S. subprime meltdown and current global credit will lead to a Japan-style lost decade, or if a quick recovery is possible. Comparing the actions of policymakers in the U.S. now with Japan's during the 1990s, there are some similarities, but the evidence thus far suggests that U.S. authorities have learnt from Japan's mistakes.

Although the U.S. Treasury secretary and Federal Reserve chairman have been criticised, one cannot fault their urgency. Unlike the Bank of Japan, the Federal Reserve has slashed interest rates in the span of months, not years, and zero interest rates appear a real possibility. As was the case in Japan, a main problem with lending appears to be insufficient demand as well as bank reluctance. On this front, government pump-priming will help lead to a recovery in the real economy and promote borrowing.

Quick injections of cash

Curtailing the messy and prolonged public debate that delayed a federal bailout in Japan, policymakers have pushed through measures that have the potential to quickly recapitalise banks. The $700 billion TARP is actually smaller (around 5% of GDP) than the bailout package approved by Japanese authorities in 1998. But unlike Japan a decade ago, U.S. authorities appear to be quickly attempting to recapitalise banks via equity purchases.

Another important lesson is that the U.S. authorities are using some discretion in choosing which financial institutions to support. The Japanese blanket approach of supporting all institutions, rather than letting some fail, did not work. While U.S. policymakers have declared a few institutions too big to fail, they have been willing to let some businesses go. A number of large U.S. financial institutions have declared bankruptcy or merged, while many hedge funds have returned money to investors and ceased operations. Although this transformation has diminished the prestige of Wall Street and the U.S. financial system, the alternative of bailing them out surely would have been a mistake. The experience of Japan’s lost decade is testament to this, and increasingly, U.S. authorities are being forced to practice triage among financial institutions.

It is still too early to tell if the U.S. approach will avoid a prolonged period of financial system ill health and stagnant real GDP, but authorities do not appear to be repeating Japan's mistakes. If the cost of the current painful actions is a brief recession to facilitate financial restructuring, it is almost certainly better that a decade of stagnation amid credit market malaise.
The shadow is a moral problem that challenges the whole ego-personality, for no one can become conscious of the shadow without considerable moral effort. To become conscious of it involves recognizing the dark aspects of the personality as present and real. This act is the essential condition for any kind of self-knowledge.
Carl Jung - Aion (1951). CW 9, Part II: P.14

Messages In This Thread
Case study of the banking crisis - Japan's "Lost Decade" - by David Guyatt - 10-06-2009, 09:53 AM

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