Japan faces a history of ten years of repeated recessions followed by stagnation. As a sharp contrast to the stable performance in and before 1980’s, 1990’s was referred to as the “lost decade” by the Japanese. This area is identified as important since Japanese banks, two decades ago, were amongst the strongest in the world and hence their decline serves as a warning and an example to the rest of the world.
In 1980s, Japanese banks surpassed the American competition and emerged stronger than the American banks, having market share of 25% of the banking businesses inCalifornia and 15% across the world. What experts failed to forecast was the burst of the bubble and the loopholes in the banking sector that already existed and hence prolonged the crisis. Such crisis not only demonstrates the considerable costs associated with such failures but how banking problems can lead to a prolonged recession period.
The weakened banking system was a key factor in the deterioration of the Japanese economy. In order to understand the problems and crisis faced by the Japanese banking sector, it is essential to review background information of the asset price bubble (1980s). According to Bank of International Settlements (2001), before 1994, there were no bank failures. Under the convoy system, it was understood that the banking system could never fail as the Ministry of Finance (MoF) closely watched over the central bank, Bank of Japan (BoJ) and this system also contributed to the economic growth, makingJapana major economic power. It is observed that a banking crisis has an average length of usually 3.9 years but Japan took around 7 years by 1998.
According to International Monetary Fund (2000), the collapse of the bubble was because of the highly overvalued Japanese stock market which peaked in 1989 and collapsed after summer 1990.The Bank of Japan (BoJ) discount rate followed similar trend. Simultaneously, the land prices were increased by MoF in 1990 which limited bank lending only to the real estate sector. From here onwards there was a subsequent slowdown in Japan’s economy along with a decline in stock and real estate prices. This weakened the health of the banking sector.This information led to a belief that real estate prices and stock prices would pick up and hence the authorities used the wait and see policy. But the wait and see policy failed in this case and to avoid dealing with bad loan problems the banks turned to falsification of their financial statements.
Problems faced by the Banking Sector
The problems of banks lengthened the recovery of Japan’s economy.
a. Non Performing Loans 
Because of the collapse of the bubble the asset prices in Japan fell drastically which caused companies to face management failures. This price fall increased the repayment burden of bank loans with real estate as collateral. Bank of Japan was actually supporting customers with poor repayment prospects. However, they failed to recognize reasons as to why this misallocation was done by the banks and if Bank of Japan knew about it, then why were appropriate actions not taken.
The real estate developers were granted loans at an increasing rate even after the industry declined in its profitability. Borrowers were allowed to roll over loans and hence, the interest kept on mounting. This was never disclosed in financial statements and that is how the real picture was kept hidden from public. Besides rolling over loans there were other ways in which banks helped weak borrowers. They could refinance the loans at lower interest rate or forgive a part of capital. Debt forgiveness was preferred in many cases over roll over loans. Debt forgiveness was a mean to reorganize a financially distressed firm but it was never successful in Japanese case. In doing so, not only the banking industry was hurt but also the whole Japanese economy.
b. Balance sheet disclosure and Basel Capital requirements
Initially only banks with international operations were set to meet the minimum capital requirement but even regional banks agreed to comply with 8% instead of their domestic capital adequacy requirement. However, by 1998 they started facing problems. Japanese banks continued to increase credit to defaulters . They asserted that the Japanese banks feared that they might fall below the minimum capital requirement because of the extent of non performing loans. Since the banks did not want to lose public confidence they extended credit to small and medium sectors.
c. Profits of Banks
Deflation held back bank’s profitability. However, these claims were not supported by any evidence. The latent profits were definitely made, mainly from capital gains in equities, government bonds and derivatives, to write off vast amount of their debts. He proved this with time series data indicating that the write-offs spread across a decade proving that “banks wrote off their bad debts whenever their capital gains situations allowed them to.”
d. Lack of Innovative Financial Products
The model followed by Japanese Banks was that of traditional banking. Various papers discussed the fee earned by such banks. The percentage for fees between US and Japanese Banks showed that the latter had low income fee but showed high reliability on interest income. The fee and commission income as a percentage of total income was alike in 1976 and 1996.This gap further created more trouble for the Japanese banks. Since most global banks had strategies with non-traditional products and associated revenue streams, Japanese banks remained ignorant.Under the convoy system, the authorization from MoF was to be sought for in case a new financial product was to be introduced. Therefore the system within the bank made it difficult to launch such products that could be competitive globally. This convoy system within the bank led to its own failure since Japanese banks could hardly gain relative advantage and profitability. Even though Japanese banks at that point of time were among the largest in the world in terms of assets yet they had very few product lines that were market leaders.
Japanese banks were not profitable also because they were slow to enter the markets and offer new products. However, Japanese had initiated “aircraft leasing” and financial deals, innovated marketing new real estate products in mostly 1980s, invented impact loans to name a few.
The problems of the banks in Japan led to a credit crunch that lowered employment and investment. The instability of the banking industry came into public view in early 1995 and by August 1995, four credit cooperatives (Tokyo Kyowa, Anzen, Cosmo and Kizu) collapsed and one of the regional banks was ordered to shut its operations due to loose supervision. The Jusen Companies, established from 1970s by banks and financial institutions for real estate lendings, gathered loans that were 74% non performing loans.
According to IMF report in 2000, in 1992, concerns on their working arose. Eventually, along with financial institutions, Jusen companies also collapsed and this heavily damaged the reputation of the Japanese banking industry.
The year 1997 marked increased distress of Japanese Financial system, heavy regulatory pressure and market scrutiny. This year was a turning point for the banking industry since there was a fundamental shift in the lending methods of the bank. In November 1997; Sanyo Securities (a security company) defaulted on interbank loan market which was followed by a series of similar events. These events generated “credit crunch” in the financial market that led to crash of the stock and real estate bubble in 1990s and loss of confidence in the auditing and accounting system of banks. At this point also regulators were quite hesitant to take stringent actions to avoid public panic. Between 1997 and 1998, three major Japanese banks failed and in order to enhance soundness of banking and restore confidence of banks in the public, the Japanese government injected public funds to get capital in the banks from 1998 to 2002.This period also followed relaxation of accounting standards.
A few indicators signalled the probability of a crisis and similar cases of financial crisis that occurred across the globe but what distinguished Japan was that it stood out of the rest due to the length of its banking crisis and the period that followed.
3. Conclusion
The debate still exists as to whether the problems were the cause or the effects of the Japanese crisis. In the second half of 2003, the Japanese economy showed improvement but this will not go a long way as the recovery will waver and then a new policy for restructuring of financial sector would be required. They felt that the policies continue to be thoughtless, with changes coming only when they are absolutely necessary. The banks still face “serious issues” and these will continue to exist till the problems of the banks are not dealt with.
The debate whether the recovery of Japan at present will continue or will end abruptly still remains an important topic of discussion. Moreover, in a recent paper it was believed that economic recovery was not going to solve the banking problems. The puzzle of how to end the crisis forever and what policies Japan should adopt for this still remains unanswered. Japanese Banking sector is seen to have faced mostly all those problems which bank, in general, should avoid namely: default risk and asymmetric information.
Existing literature covers problems of the Japanese banking industry and the measures taken by the government to end the crisis and have stable economy. They fail to cover questions about what further actions the authorities in Japan should take to ensure the soundness of their financial system, once they have recovered. Whether this reform was successful or not still remains a puzzle and a subject for future research. The way the banks would deal with the current obstacles will give a clear view whether the Big Bang was a boon or a bane and whether the banking system in Japan is strong enough to successfully counter the consequences incase of another crisis.