Reconstructing the Financial System

By the Shadow Financial Regulatory Committee (Japan)*

June 29, 1998

Contact numbers for this statement: 

In the US: Takeo Hoshi. Graduate School of International Relations and Pacific Studies, University of California, San Diego, 9500 Gilman Drive, La Jolla, CA 92093-0519; Phone:(619)534-5018, Fax:(619)534-3939.

In Japan; Mitsuhiro Fukao, Phone/FAX (home) 03-3945-3520.

1.      The current restructuring procedure, which assists mergers between weak financial institutions using public funds, should be stopped immediately because it just postpones the final resolution of the problem.

2.      The accounting standard for non-performing loans should be reformed to be as strict as that in the US.  Financial institutions whose survival is considered doubtful in the market (suggested by declining stock prices and/or increasing cost of funds) should be thoroughly examined and their assets carefully assessed.

3.      Insolvent financial institutions and those that are chronically in deficit should be put under the newly created state owned bank holding company (cum receiver in bankruptcy procedure) and be either liquidated or reconstructed.

4.      For the medium term, financial supervision should rely more on market discipline based on disclosed information and the regulators should just complement such market discipline. 

Japan’s financial system is facing its most serious crisis in the post-war period.  The government policy since the end of last year, centered around injection of public funds this spring, has not yet helped the situation.  Continued decline in stock prices of financial institutions and the depreciation of yen show the market’s distrust in Japanese banks and government that have postponed serious write-offs of non-performing loans to date.  If one takes the bank balance sheets (as of March) disclosed by banks at face value, one does not see any problems in the Japanese financial system.  The market knows, however, that the current policies including relaxation of prompt corrective action, allowing the valuation of securities based on historical cost, revaluation of the land value, and the injection of public funds without sufficient write-offs of bad loans would not solve the current problem.    

              The current government policy uses public funds to encourage weak financial institutions to merge weaker financial institutions, as Hanshin Bank’s merger with failed Midori Bank and Chuo Trust’s acquisition of the mainland part of Hokkaido Takushoku Bank clearly suggest.  This creates a serious incentive problem.  The owners of weak financial institutions would assume responsibility of failed banks just to receive public funds.  The experiences of financial crises in many other countries show that consolidation of week financial institutions merely creates larger and even weaker institutions.  The Japanese government has ignored the lesson and lost the trust of the global market.

              What the government must do is to terminate the forbearance policy credibly.  It may bring a temporary chaos to the Japanese economy because it will reveal the seriousness of the current crisis.  Therefore, it is necessary to create a scheme that will minimize such chaos.  In addition, public funds have to be used as effective as possible to avoid putting too much burden on tax payers and depositors, who will eventually pay for the public funds in the forms of higher taxes and/or higher deposit insurance premium.  

              From a long-run point of view, policies that improve the capital markets are necessary to reconstruct the Japanese financial system.  Introduction of defined-contribution pension system, expansion of investment trusts, and adjustment of infrastructure for securitization would all contribute to such improvement of capital markets. 

1.        Market Based Supervision of Financial Institutions

An important factor behind the current financial crisis is the lack of credibility in the balance sheets of financial institutions, whose most important asset is credibility.  For example, it is difficult to find any relationship between the numbers from the March 1998 balance sheets of large banks and the credit ratings by the rating agencies.  Drastic jumps in estimated losses at failed financial institutions, tobashi by Yamaichi, and a series of scandals have made MOF supervision, BOJ examination, and auditing by certified accountants anything but credible to Japan and to the whole world.

Under such circumstances, we suggest the use of criteria based on market mechanisms (instead of the publicly available accounting numbers) to decide which financial institutions should get priority of being restructured.

We suggest first identifying those financial institutions that have low stock price to net asset ratios, have difficulty in obtaining funds without posting significant collaterals, are required to pay high premium, or are assigned low credit ratings.  Then, those financial institutions would go through comprehensive inspection and careful evaluation of assets.  We suggest using the US accounting standard (Code 114, 118), which is much stricter than the Japanese for the evaluation of loans.  The standard would immediately recognize the losses in loans with interest concession and partially incollectable loans by reducing the book value of those loans to the presented discount values (using the initially contracted interest rate) of the future cash flows.

After the thorough inspection of assets, if the financial institutions were found to have either negative equity or to be chronically in deficits, they would be declared to have failed.  They would be put under the authority of what we tentatively call Financial Institutions Restructuring and Reconstruction Corporation (FIRRC), which is state owned bank holding company to be created.  Under FIRRC, the financial institution would go through a serious restructuring, including elimination of shareholders’ equity and subordinated debts, firing of directors, and downsizing of payroll.

The goal is to eliminate those financial institutions that have no chance of surviving and to put those with hope of survival on the right track by restructuring them.  Unnecessary bankruptcies of the borrowers in this process, however, must be avoided.  There are some borrowers that have avoided bankruptcies just by meeting their interest payment through additional loans.  Those companies should not be permitted to circumvent bankruptcy.  Borrowers in good financial condition, however, should not go bankrupt under the process of cleaning up the financial institutions.  To achieve this goal, we suggest the establishment of FIRRC, which is described more fully in the next section.

2.        Working of Financial Institutions Restructuring and Reconstruction Corporation (FIRRC)

FIRRC would be established as a state owned bank holding company, and function as a de facto receiver in bankruptcy and restructuring process.  It could be considered as an emergency hospital where failed banks would be nationalized and treated.  If nationalized institutions could be cured there, they would be given a chance to be privatized and restart.  However, if there would be no cure, they would be liquidated promptly while FIRRC tries to prevent the contagion (bankruptcy of the borrowers).  As for the methods of treatment, there would be extractions of tumors (to remove the bad part of the category 2 loans and all of category 3 and 4 loans, and to entrust Resolution and Collection Bank with bad loan collection), development of physical strength (to change management, and to slim down payroll and branches), and blood transfusion (capital injection).  Capital injection, however, is extremely expensive.  Therefore, its use must be limited to a few financial institutions with good prospects for future profits

A typical process of dealing with a failed financial institution would proceed as follows.  When a financial institution is found to be in distress through the aforementioned examination, it is put under the authority of FIRRC.  If the financial institution is insolvent, Deposit Insurance Corporation (DIC) makes up for the excess liability.  After removing bad loans from the balance sheet, FIRRC decides whether the bank can be viable after proper restructuring.  If it is deemed to be viable, it is sold in the market after having cleaned up the balance sheet and injected minimal amount of capital.  On the other hand, if it is decided not to be viable, it is liquidated while protecting the healthy borrowers from bankruptcies by extending new loans.

We recommend that the state owned FIRRC should be privatized within five years.  It must have a public offering no later than five years from establishment.  At the time of public offering if its liability exceeds its assets, the deficit would be made up by transfer from the general account of the government.  This process is crucial in order to prevent FIRRC from following the example of Japan National Railway Liquidation Corporation and becoming another device to postpone the final resolution of insolvency.

 FIRRC must minimize the costs of managing failed banks and maximize collection revenue from valuable assets.  Government discretion in the name of saving borrowers must be avoided at all cost.  Otherwise, FIRRC would become just another nest for bad loans.  To avoid this, regular outside auditing by public auditors and financial specialists and the disclosure of audit results will be necessary.

Furthermore, FIRRC should investigate and bring legal actions against the current or past management of failed banks if they were suspected of any breach or window dressing.

3.        Establishing a New Framework for Financial Supervision

From a long-term perspective, it is important to establish a new framework for financial supervision.  We will list below the necessary elements for such a framework.  We believe the financial regulators should implement all of the elements in the medium run.

First, in order to regain the trust for financial statements of banks, financial institutions should be required to use the US GAAP as the accounting standard and require public auditors to report all illegal accounting and that they encounter to the regulators.  The same level of disclosure and public auditing should be required also for mutual life insurance companies and cooperatives.  It is especially important to disclose the market value of debt for life insurance companies, which own a huge amount of high yield debts.

              Second, the financial regulators should enforce the disclosure, and utilize market information in financial supervision.  For example, it could require financial institutions to finance a part of their capital with fixed-term subordinated debt that is traded in the market.  If the return of the debt exceeds the return of government bond by more than a certain amount, the regulatory authority would increase the deposit insurance premium or shorten the examination interval.  Companies related to a financial institution or other deposit-taking financial institutions should be prohibited from owning the subordinated debt issued by the financial institution, so that the subordinated debt could function as a valid indicator of the market valuation for the financial institutions.

Third, the law should be revised that the Deposit Insurance Corporation (DIC) could take legal actions against directors, controllers, or auditors of financial institutions on behalf of the depositors when depositors are injured because they manipulated financial statements, did insufficient auditing, or impaired the institution’s assets.  There is a serious defect in the current system because DIC cannot pursue the legal recourse against the relevant parties of failed financial institutions when DIC endows capital to the financial institution. 

Fourth, the financial regulators should disclose all the administrative actions against financial institutions.  In another word, the regulators themselves should disclose information, and should terminate the discretionary supervision that relies on private information.

Fifth, the regulators should require financial institutions to adapt a legal compliance program (legal education for officers and employees).

Finally, the regulators should require financial institutions to establish a board of auditors only including outside auditors or a supervisory committee only with outside directors.