Shadow Financial Regulatory Committee (Japan) Statement #3

Urging a Proper Implementation of Prompt Corrective Action, Financial 
Revitalization Act, and Bank Recapitalization Act

December 8, 1998

The members of Shadow Financial Regulatory Committee in Japan are: Mitsuhiro 
Fukao (Keio University), Chair; Kazuhito Ikeo (Keio University), Takatoshi 
Ito (Hitotsubashi University), Mitsuru Iwamura (Waseda University), Yuri 
Okina (Japan Research Institute), Hideki Kanda (University of Tokyo), Yutaka 
Kosai (Japan Economic Research Center), Akiyoshi Horiuchi (University of 
Tokyo), Takeo Hoshi (University of California, San Diego).  Mitsuru Iwamura 
could not participate in the process of drafting the current proposal.  The 
committee acknowledges the financial support from Tokyo Center for Economic 
Research.

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, e-mail: thoshi
@ucsd.edu
In Japan; Takatoshi Ito, Phone/Fax (home) 81-3-5724-5808, e-mail: ITOINTOKYO
@aol.com
Mitsuhiro Fukao, Phone/Fax (home) 81-3-3945-3520, e-mail: fukao@fbc.keio.ac.
jp

Summary of the statement
1. The regulatory authority and policy makers should:
(1) implement Prompt Corrective Action, Financial Revitalization Act, and 
Bank Recapitalization Act strictly in their stated purposes.
(2) use public funds to recapitalize a bank only when the bank successfully 
raises additional capital on their own efforts in the market.
(3) require banks to disclose the exact amount of nonperforming loans with a 
rigorous application of classification.
(4) clarify the responsibility and the scope of the regulatory authorities.
(5) clearly define the objectives of the manager of a nationalized bank or a 
bank under receivership, so that those banks can be sold off or re-
privatized without undue delay.
2. Bank managers and the public should recognize:
(1) that it is utmost important to formulate a clear plan to make Japanese 
banks profitable in the near future.
(2) that restructuring of banking industry inevitably apply further downward 
pressure to the economy.
(3) that substantial decline of indirect finance is inevitable.
(4) that restructuring and scale reduction alone cannot improve the quality 
of bank management.  The Japanese banks need forward looking strategies to 
survive the international competition.

1. Implementation of Financial System Stabilization Policy
(1) The regulatory authority should implement Prompt Corrective Action, 
Financial Revitalization Act, and Bank Recapitalization Act strictly in 
their stated purposes.

The regulatory authority must not apply Bank Recapitalization Act to 
recapitalize insolvent banks or banks with negative going concern value (in 
the sense they are not likely to yield profits in the future).  An insolvent 
bank should be put under a national receivership under Financial 
Revitalization Act.  Prompt Corrective Action should be applied to a solvent 
but undercapitalized bank before it receives public funds for 
recapitalizatoin.  By applying these laws properly, the regulatory authority 
can induce correcting the state of overbanking.

In applying Bank Recapitalization Act, banks' security holdings should be 
evaluated using the lower of their historical costs and their market value.  
The classified loans should be evaluated as the present discount value of 
the future recoverable amounts.  When a bank effectively guarantees 
borrowings by insolvent customers, the expected loss should be subtracted 
from bank capital.  Currently, all the general loan loss reserves are 
included in the broadly defined bank capital, but the reserves for expected 
loss from substandard loans should be excluded from capital.

When Hokkaido Takushoku Bank failed last year, and when LTCB (Long-term 
Credit Bank) was nationalized this year, their subordinated debts were not 
subordinated under those circumstances.  The regulatory authority should 
scrutinize the subordination clauses for subordinated debts, and those debts 
that would not be subordinated when a bank is nationalized or is put under 
national receivership as specified in Financial Revitalization Act should be 
excluded from bank capital (possibly after 5 years or so of transition 
period).

(2) The government should use public funds to recapitalize a bank only when 
the bank successfully raises additional capital on their own efforts in the 
market.

The government should use public funds to recapitalize a bank only when the 
bank successfully raises additional capital on their own efforts in the 
market.  Since Bank Recapitalization Act aims to help banks that are 
undercapitalized but have positive going concern value, the government 
should not inject public funds into banks whose viability is doubted by the 
market.

Public funds should be use to recapitalize the bank itself, rather than its 
subsidiaries or SPC (Special Purpose Companies).  The Financial Supervisory 
Agency is on the right track on this issue.  When the government purchases 
preferred shares to recapitalize a bank, the bank should be allowed to 
deduct the dividend payments on the shares for corporate tax purposes to 
avoid burdening the bank with high dividend payments.

According to the media reports, the banks that accept public funds would be 
required to increase their loans to small and medium enterprises.  It is 
true that injection of public funds increases risk-taking capacity of banks 
and increases their lending capacity.  When the banks extend loans, however, 
the banks should exercise their own judgement on whether the expected 
profits on the loans are high enough to compensate for the risk.  It is 
wrong for the government to impose the quantity target for the amount or 
growth of such loans.

The preferred shares purchased by the government must be preferred not only 
in payout of dividends but also in division of proceeds from liquidation.  
To achieve the fairness between shareholders, the potential voting right of 
a preferred share should be made proportional to the paid-in amount of the 
preferred share relative to the market price of common share.  It is 
desirable to make the preferred shares convertible into common shares, so 
that the government can gain from share price increase following successful 
restructuring of banks.

The subordinated debts bought by the government should be subordinated to 
other debts when the bank is nationalized or put under national receivership 
defined in Financial Revitalization Act.

(3) The regulatory authority should demand banks to thoroughly disclose the 
amount of bad loans.

The regulatory authority should demand Japanese banks to start using IASC 
(International Accounting Standards Committee) or FASB (Financial Accounting 
Standard Board) standards.  Ever changing disclosure standard for bad loans 
for Japanese banks has been seriously hurting the credibility of Japanese 
financial system.  Each bank should be required to disclose all the problem 
loans for the consolidated account, classified according to the extent of 
loan losses.

The regulatory authority should publish the standard reserve ratios for bad 
loans based on the present discount values of collectible amounts.  If a 
bank chooses to use non-standard reserve ratios, the regulatory authorities 
should require the bank to explain in detail.

(4) The government should clarify the responsibility and the scope of the 
regulatory authority.

Demarcation among various supervisory authorities - Financial Revitalization 
Committee, Financial Supervisory Agency, Ministry of Finance, Deposit 
Insurance Corporation, and the Bank of Japan - must be clarified by the 
government.  The scope of responsibilities has to be clearly defined.

For instance, many examiners at Financial Supervisory Agency formally belong 
to Ministry of Finance and the ministry rather than the agency handle their 
personnel matters.  We believe the situation is problematic and suggest the 
complete transfer of the examiners to Financial Supervisory Agency.

At the same time, Financial Supervisory Agency is seriously underfunded and 
understaffed.  The government should provide funding and staff that are 
sufficient to carry out prompt examinations of problem banks.

(5) The government should clearly define the objectives of the manager of a 
nationalized bank or a bank under receivership, so that those banks can be 
sold off or re-privatized without undue delay.

The government should provide incentives to the managers of nationalized 
banks, such as LTCB, so that they try to re-privatize the banks as fast as 
possible.  For example, the government may wish to pay an extra bonus to the 
managers who can privatize the failed financial institutions quickly.

2. Reconstruction of Banking Industry and Financial System
(1) Bank managers need to formulate clear plans to make their banks 
profitable in the near future.

Managers at major banks should be responsible in formulating a clear plan to 
regain the confidence of the market.  They should present a clear picture on 
how recapitalization with public funds help the banks to regain the 
profitability, how quickly they plan to shed non-profitable business lines, 
and which business areas they plan to focus on.

(2) Restructuring of banking industry inevitably apply further downward 
pressure to the economy.

Making the financial system free from burdens of non-performing loans is 
necessary for the Japanese economy to resume growth in the medium-run.  
Reorganization of banks and restructuring of banking industry, however, will 
deepen the recession in the short-run.  Many insolvent and unprofitable 
corporations, which have been supported by their banks, are likely to fail.  
The exit of unprofitable firms naturally accompanies the necessary 
structural shift of the Japanese economy.  A drastic policy is desired to 
achieve the structural adjustment at the minimal social cost.

(3) Substantial decline of indirect finance is inevitable.

Injection of public funds to the banking sector may stop the competitive 
collection of bank loans, but the amount of bank loans has been declining 
for structural reasons.  Banks have to obtain adequate profit margin so as 
to cover the expected loan loss rates.  This is likely to increase the 
average loan interest rates.  

(4) Restructuring and scale reduction alone cannot improve the quality of 
bank management.  The Japanese banks need forward looking strategies to 
survive the international competition.

Across the board wage cut may help the harmony among employees by 
maintaining the existing wage structure, but may encourage talented 
employees to leave.  In order to survive the international competition in 
financial services, retaining talented people by recognizing their market 
value becomes increasingly important.  Bank managers may want to introduce 
the salary structure that more reflects the difference in productivity of 
individual employee.  They may try reducing the total number of employees 
while increasing the average salary for the remaining employees.