RDP 2000-03: Some Structural Causes of Japan's Banking Problems 1. Introduction

At the start of the 1990s, Japanese banks were held in reasonably high regard. There was a consensus in industrial organisation theory that they selected and monitored their industrial clients efficiently and that they met the need for corporate governance in a way that the takeover market could not. For this reason, it was widely believed that financial intermediation was one source of the productivity growth that had fuelled Japan's postwar economic expansion (Calder 1993).

By the end of the decade, those impressions had dissipated. Growth had stagnated, and in ways that reflect badly on the banks. By disrupting financial intermediation, the non-performing loans of Japanese banks have constrained investment for the better part of a decade. In 1998, they were equal to roughly 25 per cent of GDP (Lincoln 1998), and at the end of March 1999, they still constituted 12 per cent of outstanding credit exposure (OECD 1999, p 87).

Some of the longer-term causes of those problems lie in the deterioration of banks' loan portfolios which occurred during the 1980s. Over this period, banks developed large exposures to borrowers who were either very vulnerable to falling asset prices or were, for other reasons, not very creditworthy. Not only did banks accept substantial credit risk by targeting these borrowers, they apparently attenuated their monitoring and screening of them.

This paper surveys some of the literature which explains the deterioration in the quality of the banks' loan portfolios. It focuses on two hypotheses that have emerged in the corporate finance literature. The first is that capital market reform over the 1980s encouraged high-quality borrowers to secure disintermediated forms of finance, with the result that an adverse selection problem developed in the Japanese bank lending market. The second is that the simultaneous deregulation of the wholesale funds and retail lending markets compressed the margins of banks. Given the various safety nets in operation in Japan at the time, it was rational of the banks to respond to the reduction in their franchise values by targeting borrowers which presented greater risks but offered higher nominal rates of return. Much of the accumulated exposure of banks to firms which were vulnerable to the asset price collapse of the early 1990s can be understood in terms of these two ideas.

Macroeconomic developments inform both arguments. During the 1970s, economic growth began to slow. This required financial reform, which in turn, eventually caused some dislocation of the domestic banking system. The problems worsened in the late 1980s, as monetary policy was eased in response to falling consumer price inflation and an appreciating nominal exchange rate. This substantially eroded the franchise values of banking.

The next section presents a stylised overview of Japan's corporate finance markets prior to the 1980s. Section 3 profiles the subsequent deregulation of the system, and it reviews some of the theories which relate the changes in the corporate finance market to the changes in bank behaviour. The final section summarises the analysis.