Japan's Banking "Crisis"

CRS Report for Congress
Japan’s Banking “Crisis”
Dick K. Nanto
Specialist in Industry and Trade
Foreign Affairs, Defense, and Trade Division
The Japanese economy is burdened by an overhang of nonperforming bank loans that
are officially recognized to total $367.5 billion but could exceed a trillion dollars if all problem
loans are taken into account and economic conditions worsen significantly. These bad loans
have weakened Japan’s already sluggish economy, undermined the strength of the yen, and
are exacerbating the slowdown in Asia’s economies. In recent years, Japan has averted a
replay of the crisis conditions that accompanied earlier failures of financial institutions, but the
problem is immense, and restoring health to the balance sheets of Japanese banks remains a
top economic policy concern both in Tokyo and in international financial circles. After nearly
a decade of repeated attempts to resolve the problem, the current Koizumi government has
set a new deadline for banks to write off the worst of the loans within three years even if this
causes as many as 200,000 lost jobs and numerous bankruptcies. The United States and
Japan have initiated a Financial Dialogue led by the U.S. Treasury to discuss various financial
issues – including the bad loan problem – and the Bush Administration has said it would assist
Japan in pursuing its economic reforms in any way it can.
The nonperforming loans held by Japan’s banking sector total at least $367.5 billion
despite a decade of government programs to strengthen its banks and private efforts to clean
up the mess. This mammoth challenge facing Japan’s financial sector is of interest to the United
States because this huge debt problem weakens Japan’s economic performance, is dragging
down other neighboring economies in Asia, undermines the strength of the yen, and affects the
financial flows between the United States and Japan. It also can affect American trade and
investments in Japan. In addition, as the second largest economy in the world, Japan’s
economic weakness, along with the slowing economy of the United States, are key to the
export performance and stability of many export-dependent countries in Asia. The overhang
of bad loans also contributes to weakness in Japan’s capital markets and a shortage of capital.
Despite Bank of Japan interest rates of less than 1%, small- and medium-sized businesses in
Japan face relatively high interest charges and a reluctance on the part of banks to lend them
funds. Japanese banks also have been reducing their lending in international markets,
particularly in Southeast Asia. Tokyo recognizes that the country is in danger of becoming a
second- or third-rate power if it does not restore health to its economy – beginning with the
banking sector.

Congressional Research Service The Library of Congress

As of March 2001, deposit taking financial institutions in Japan held an official total of
¥43.4 trillion ($367.5 billion) in nonperforming loans (up from ¥42.4 trillion in March 2000).
(See Appendix.) Of the ¥43.4 trillion, banks held ¥32.5 trillion, and cooperatives held ¥10.9
trillion. The nonperforming loans were categorized as those to borrowers in legal bankruptcy
(¥4.9 trillion), loans in arrears six months or more (¥24.0 trillion), loans in arrears three to six
months (¥0.8 trillion), and restructured loans (¥13.8 trillion).1 The nonperforming loans account
for 6.9% of total loans (5.7% for major banks). These official figures, however, are thought to
be understated. If one includes problem loans that might go sour if the economy goes into
recession, the total could be as high as ¥140.9 trillion ($1.13 trillion).2 Also, only about 30%
of the bank loans to firms that recently have gone bankrupt had been listed as nonperforming.
For most Japanese banks, only extensive government efforts and financing of bank
recapitalization packages have kept them from bankruptcy or severe punishment by stock and
lending markets. Even with government intervention, Fitch (an international rating agency) rates
the intrinsic strength of individual Japanese banks as D or D/E (the bottom of the scale),
although Fitch gives ratings mostly of A or A- on long-term debt for major Japanese banks.
This is based on the theory that the banks’ long-term debt instruments are of relatively higher
quality because the Japanese government would intervene to support them if necessary.3 The
poor condition of Japanese banks did cause a “crisis” in 1997-98 when they had to pay a
premium of as much as 0.7 percentage points over international bank borrowing rates to
compensate lenders for their increased risk.
The new Koizumi administration has announced its intention to restructure the Japanese
economy and to resolve the nonperforming loan problem. The United States and Japan also
have been engaged in what is called the U.S.-Japan Economic Partnership for Growth,
launched by President Bush and Prime Minister Koizumi at a Camp David summit on June 30,
2001. This Economic Partnership includes a Financial Dialogue which is to serve as a forum
for the U.S. Department of the Treasury and Japan’s Ministry of Finance and Financial Services
Agency to exchange information and views on a range of key financial issues, including non-
performing loans of Japanese banks.4 In June 2001, U.S. Federal Reserve Chairman Alan
Greenspan reportedly urged Japan to immediately embark on the task of disposing of bad loans
in the banking sector.5

1 Japan. Financial Services Agency. Non Performing Loans of All Deposit-taking Financial
Institutions (as of the end of March 2001). August 2, 2001.
2 Japan Digest, August 3, 2001. P. 2.
3 These are not debt ratings but rather an assessment of the intrinsic strength of each bank
assuming no governmental or other external support. See: Fitch IBCA on Internet at
4 U.S. Trade Representative. Fact Sheet. The U.S.-Japan Economic Partnership for Growth.
June 30, 2001.
5 Urakama, Kenji. US Federal Reserve Chief urges Japan to Clear Bad Loans Immediately.
Kyodo News Service. June 1, 2001.

In June 2001, the Koizumi government declared that banks must dispose of loans to
bankrupt and near-bankrupt borrowers within two years and remove newly emerging
nonperforming loans within three years of such classification – even at the cost of 100,000 to
200,000 jobs in troubled companies.6 Given Prime Minister Koizumi’s popularity rating of over
80%, he may succeed in pushing through reforms that heretofore have been stymied by
powerful interest groups. The program is being criticized by some as being too limited, while
entrenched financial interests are attempting to reduce its scope. A problem is that the Prime
Minister also is attempting to curtail deficit spending which could slow the economy so much
that new bad loans will appear and banks will be unable to generate the profits needed to
finance the bad loan write-offs. A counter risk is that if drastic action is not taken now, the
situation will only worsen.
The genesis of Japan’s problem with nonperforming loans can be traced to two structural
factors. The first is the burst of Japan’s so-called economic bubble in 1989. During the latter
half of the 1980s, Japan’s monetary authorities flooded the market with liquidity (money) in
order to enable businesses to cope with the rising value of the yen. Businesses did invest in new
capital equipment to become more competitive in international markets, but the excess liquidity
also found its way into speculation in Japan’s stock market, in real estate ventures, and in
foreign investments. At that time, the market value of both land and equities was rising so fast
that investors and speculators could hardly miss. The larger mistake for them was not to
borrow and invest and consequently not be positioned to reap the returns from rising markets.
Banks considered most loans with real estate as collateral as being unquestionably secure.
When Japan’s economic bubble burst in 1989 causing stock and land prices to fall, the
value of collateral underlying many loans dropped below the value of their loan principal.
Commercial real estate ventures, especially office buildings, also became unprofitable as rents
fell. As the economy slowed, companies also faced excess capacity and inventories and lower
profits. As more and more loans turned sour, more and more of the underlying real estate had
to be sold at “bargain” prices. This only drove land values further down – particularly for
commercial real estate in the major urban areas.
As shown in Figure 1, Japan’s Nikkei stock market average peaked in 1989 at 40,000
and subsequently has dropped by more than half to roughly 12,000 in August 2001. Unrealized
capital gains on holdings of stock by major banks which stood at ¥49.1 trillion ($355 billion)
in 19897 has dropped to approximately ¥5 trillion ($42 billion) in 2001. For some weaker
banks, stock holdings have resulted in capital losses. Commercial land values in the six major
metropolitan areas peaked in 1991 and by 2000 had fallen by 80%. The value of residential
and industrial land (which are combined with commercial to form the All Urban land price
index) fell by less, but still declined by nearly 20%.

6 Dvorak, Phred and Peter Landers. Japan Weighs Stiff Measures for Economy. The Wall
Street Journal, June 22, 2001. P. A11.
7 J.P. Morgan Securities Asia. Japan’s Bank Problem is About to See Policy Action. Economic
Research Note. March 2, 2001.

Figure 1. Japan’s Nikkei Stock Market Average andThe second
Prices for All Urban and Commercial Urban Land, 1985-cause of the bad loan
2000problem has been
the structure of
40120All Urban Land PricesJapan’s capital
markets. During
35100(right scale)most of the post-
30World War II
period, Japan’s
2580banking system
2060provided a
mechanism to
1540Nikkei Stock Average (left scale)transfer savings from
10the household sector
520Commercial Urban Land Pricesto the businesssector. The system
00(right scale)favored business
85868788899091929394959697989900investment and
Source: Bank of Japan. Financial and Economic Statistics Monthly. household saving
while it discouraged
household con-
sumption and consumer debt. Banks also operated under a “convoy” system in which the
government oversaw and intervened extensively to ensure not only that banks followed its
official policy line but that stronger banks helped weaker banks in order to keep the convoy of
domestic banks moving along together. One result of this system was that banks tended to lend
on a “relational” rather than purely economic basis (crony capitalism). Also an implicit
government guarantee of deposits in the banking convoy created a moral hazard that
encouraged lending to borrowers who might have been considered substandard by more
independent credit evaluators. The moral hazard stems from the government guarantee of
deposits which tended to foster risky lending behavior by banks which then exacerbated the
problem of bad loans the government guarantee was to have alleviated.
Over the 1990s, the Japanese government announced various programs and measures to
resolve the problem of nonperforming bank loans. This included ¥1.8 trillion ($13.75 billion)
in public funds injected into 21 major banks in 1998 and ¥7.5 trillion ($62.5 billion) in public
funds that included ¥5.6 trillion ($46.7 billion) allocated to be transferred to the top tier of
Japanese banks through the sale in 1999 of new preferred bank shares to a government-run
organization.8 The government has the option of converting these preferred shares – which
convey a priority claim on dividend payments but no voting rights – into common stock after
certain periods of time. The government can convert the preferred shares to common stock if
a bank misses its dividend payments. The government furthermore has replenished funds in its
woefully undercapitalized deposit insurance fund and nationalized two banks before selling them
to private investors (the defunct Long-Term Credit Bank of Japan was bought from the
government by the New York-based Ripplewood Holdings). For much of the 1990s,

8 For details, see: Choy, Jon. Banks Go Hat In Hand to Tokyo. JEI Report, March 19, 1999.

Figure 2. Total and Cumulative Direct Writeoffshowever, the hope of the
of Nonperforming Loans for Japan’s Banksgovernment was that if it
FY1991-2000could keep banks operating,
their profits from operations
and capital gains from equity
40holdings could fund the write-
32.531.335offs of bad loans. Despite
28.529.829.630.428.230billions of dollars in write-
24.325Nonperforming Loansoffs, however, nonperforming
21.819.6loans are appearing as fast as
20they are being disposed of.
12.813.612.511.3Direct Between FY1992 and
7.910WriteoffsFY2000, Japan’s banks had
5.35written off a cumulative total
0.42.50of ¥31.3 trillion
FY9192939495969798992000(approximately $275 billion)
in bad loans, but new ones
Note: Bankrupt loans, Past due loans, & (from 1995) Restuctured loans. Source: Japan, Financial Services Agencyhave appeared so fast that
the total for bad loans keeps
increasing. (See Figure 2.)
In response to the banking problem and in line with the general liberalization of Japan’s
financial markets, Tokyo also has been deregulating its financial sector. In what the government
has termed its Big Bang, various reforms have been announced that are aimed at making
Japan’s financial markets more efficient, transparent, global, and fair. In addition to new
standards, products, supervision, and reporting requirements, the government lifted the half-
century-old ban on holding companies. These banking sector changes along with the bad-loan
problem have induced a wave of mergers among Japanese banks.
On August 15, 2001, the Bank of Japan announced that it intended to pump more money
into the economy by implementing a monetary policy aimed at fighting deflation by increasing
cash balances at banks and by buying more government bonds. This may slow the decline in
Japan’s asset prices and help banks deal with their bad loans.
U.S. Policy Options
The policy options for the United States with respect to Japan’s banking problem are
limited considering the broad implications of the situation for U.S. economic and financial
interests. Congress has held hearings on the banking problems and economic conditions in
Japan. Under the Clinton Administration, the United States pressed Japan to pursue stronger
actions to recapitalize banks and to resolve the problem, but the Bush Administration appears
to have opted merely to express U.S. support for whatever policies Japan adopts. During a
July 2001 visit to Japan, Secretary of State Colin Powell stated that the U.S. stood ready to
assist in any way it could to help Prime Minister Koizumi in his efforts to reform the Japanese
economy and to clean up the Japanese banking sector. He also stated that a “vibrant Japanese

economy is a key to America’s prosperity and to Asia’s growth.”9 The Financial Dialogue led
by the U.S. Treasury on the U.S. side provides a forum for the two countries to exchange
information and views on Japan’s banking problem and other issues. It also is in the interest
of the United States to ensure that Japan pursues solutions to its banking woes that provide the
widest access to Japan’s financial services sector to U.S. investors, exporters, and
Currently, the financial situation in Japan bears close watching. A significant change in
certain indicators could portend a worsening of the problem and possible need for counter-
actions on the U.S. side. These indicators include a large fall of values on Japan’s stock market
and in real estate markets, a sudden jump in the rate of bankruptcies – particularly of financial
institutions – a reappearance of the “Japan premium” in international borrowing, or any failure
by Japanese banks to meet their capital adequacy ratios.10 A true banking crisis characterized
by multiple bank failures and a run on deposits seems unlikely at this time. However, as
Japanese banks cope with sluggish economic conditions and write off more nonperforming
loans while attempting to cut costs and integrate operations with other banks as a result of
mergers, they face particularly difficult and precarious times.
Appendix. Nonperforming (Risk Management) Loans of Japanese
Deposit-Taking Financial Institutions
(As of March 2001)
Non-performing LoansLoan
LoansReservTotalBankrupt PastRestructure
City Banks12,8959528,1043,838238,9454,852
Credit Banks3,1675361,0911,53931,7561,185
Trust Banks3,2192951,6331,29142,887902
Major Banks19,2181,78310,8296,668313,5886,939
Banks 13,234 1,547 7,634 4,054 180,601 4,616
All Banks32,5153,33018,46410,721494,18911,555
Cooperatives 10,934 1,568 6,319 3,047 132,268 3,719
Total 43,448 4,897 24,782 13,769 626,457 15,274
Source: Japan. Financial Services Agency.

9 Powell, Colin L. Press Briefing with U.S. Ambassador to Japan Howard Baker, American
Embassy, Tokyo, Japan. July 24, 2001.
10 Japanese banks currently meet the 8% capital-output ratio required for international banks, but
the depressed stock market and new reporting requirements may cause some weaker banks to
report capital losses on their stock holdings.