Urging a Political Decision to Avoid the Japanese Financial Meltdown*

By the Shadow Financial Regulatory Committee (Japan)**

September 9, 1998 (immediate release)

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; Takatoshi Ito, Phone/FAX (home) 03-5724-5808.

Summary

1. The difference between the two proposals on addressing financial crisis (draft bills in the Diet)-one by the government-LDP (LDP plan, for short) and the other by the opposition parties (Opposition plan, for short)-is not large. Some form of compromise between the two without damaging the spirits of the both bills is possible and highly desirable.

 2. We propose a restructuring procedure that is consistent with an idea that a big bank is "too big to close" rather than "too big to fail."

 3. In order to avoid moral hazard, bank management should be replaced and current shareholders equity claims should be written down, before any public capital injection. A large-scale financial institution that needs public capital injection must continue honoring all liabilities to avoid systemic risk, while assets and liabilities are being winding down. We propose a legislation that would allow the regulatory agency to write down equity claim of an essentially failing institution without the shareholders' meeting.

 4. The Long-term Credit Bank (LTCB)'s shareholder claims should be written down before the public capital injection. Precommitment of merger with the Sumitomo Trust Bank is not necessary or desirable.

5. Politicians should be decisive, prompt, and ready to make compromises.

* This is an English version of the statement written in Japanese. The original statement is longer and more detailed. The original has appeared in September 9 issue of Nikkei Kin'yu Shimbun in its entirety.

** 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)

Urging a Political Decision to Avoid the Japanese Financial Meltdown

By the Shadow Financial Regulatory Committee (Japan)

September 9, 1998 (immediate release)

I. Common Objectives.

LDP and Opposition plans share many common grounds.

(1) All deposits should be protected.
(2) When a financial institution fails, public assistance can be used to protect depositors and innocent third parties (other creditors and borrowers).
(3) Managers and shareholders of a failed financial institution should be held responsible for the failure.
(4) Truly solvent borrowers should be protected.
(5) Contagious failures of financial institutions should be avoided.

We support these objectives.

II. Differences are Small.

Difference between the LDP and the Opposition plans is small.
The major differences are:

(1) Whether, and under what conditions, public money should be injected to a financial institution that has not formally failed.
(2) How much information over balance sheets of financial institutions (especially the ones that accept public money) should be disclosed to the public.
(3) In the LDP proposal, a failed financial institution is first managed by a "financial manager (receiver)" and then, unless it is immediately purchased by another financial institution, transformed into a state-owned bridge bank. In the Opposition plan, a failed financial institution is immediately liquidated or nationalized without the interim period of state management.

These differences are less important than the objectives common to LDP and Opposition plans. Some form of compromise is possible and essential for stability of the financial markets.

III. Principles of dealing with essentially failed large-scale banks.

We propose the following principles that should be observed in restructuring a big bank whose immediate liquidation may trigger a systemic risk. These principles materialize the common objectives of LDP and Opposition plans mentioned above.

(1) No public capital injection without prior write down of equity capital
(2) Full information disclosure
(3) Protection of all depositors and (non-subordinated) creditors
(4) Consistency with restructuring of the banking industry
(5) Credibility of financial examination and supervision

These principles will be explained in detail in the next section. The government has suggested that "a big bank cannot be failed," but without specifying what is a "failure," the argument confuses the public debate. We consider that any institution which requires public assistance can be deemed "essentially failed" regardless of its status of solvency. There is a way to deal with a large-scale financial institution without causing systemic risk.

IV. Principles for public capital injection.

(Principle #1) No public capital injection without prior write down of equity capital

To prevent moral hazard, it is imperative to impose losses on shareholders of failed financial institutions as well as its managers. We urge politicians to pass a legislation that allows financial institutions can be forced to write down the equity capital without a special resolution of shareholders meeting, creditors meeting, or a bankruptcy court procedure. Also desirable is another legislation that makes subordinated debt holders to take losses for the institutions that receive public capital injection, even without a formal bankruptcy court procedure.

(Principle #2) Full Information Disclosure

To prevent ad hoc political intervention and to limit excessive discretion (and forbearance) by the regulators, thorough disclosure of information is necessary. Especially financial institutions that ask for assistance by public money should be required to reveal relevant information such as the amount of classified loans, their assumed recovery values, identities of large insolvent customers, and financial information on the related companies (subsidiaries) under their control.

(Principle #3) Protection of all depositors and (non-subordinated) creditors

We are against the idea of "too big to fail," but we believe that a large-scale financial institution can be "too big to close." Because a big bank has so many and intricate financial transactions, it would take a substantial amount of time to recover assets values without causing systemic risk. It makes more sense to put an essentially failed big bank under temporary government control and let it continue its operations, until it is restructured, and sold to a healthy institution or liquidated.

(Principle #4) Consistency with restructuring of the Banking industry

Public assistance of banking sector must not hinder necessary structural reform of the Japanese banking sector to recover its productivity and efficiency. The Japanese economy has been in the state of overbanking for the past decade. Given that the traditional banking business would be eroded by development of capital markets and globalization, amount of human and non-human resources dedicated to traditional banking business is expected to decline. Public capital injection and restructuring of essentially failed institutions should be consistent with this reality.

(Principle #5) Credibility of Financial Examination and Supervision

Financial supervision and regulatory agencies, which oversees restructuring of failed banks (with a possibility of using public capital injection), must be independent from political intervention and their code of conduct and mandate should be clearly spelled out by set of established rules. All the financial regulators, including Ministry of Finance, Bank of Japan, Deposit Insurance Corporation, Financial Crisis Management Committee, and Financial Supervisory Agency, seem to have failed to establish such credibility so far. It is important to clarify the responsibility and mandate of each regulatory authority and regulatory relationship among them. This is important for establishing credibility.

V. Strengthening regulatory power.

To implement "too big to close" approach following the principles listed above, and to rescue the Japanese financial system from crisis, we need a powerful financial regulation. For example, the regulator should be able to limit the bank shareholders right to allow capital write down without a resolution at shareholders meeting. Since the regulatory power of supervision agencies are to be strengthened, its responsibilities are also immensely important. Their independence has to be guaranteed by legislation, and top regulators have to be experts and dedicated (as full time job, and avoiding conflict of interest) on the subject.

VI. LTCB Problem.

The sticking in dealing with LTCB is whether to inject public capital prior to its merger with the Sumitomo Trust Bank. The LDP insists that it is necessary, and the Opposition insists that it should not be done. There is a way to bridge the difference when the importance of principles listed above are recognized.

The plan of LTCB to be merged with the Sumitomo Trust Bank, as it is currently reported, does not seem to satisfy some of the principles listed above. For example, the plan does not seem to require write down of equity capital of LTCB before the merger. The government seems to try using the merger as an opportunity to effectively reduce LTCB's capital by setting a tilted equity swap ratio. However, the Sumitomo Trust insists that balance sheets should be cleaned before the merger, which requires public capital injection. Injecting capital prior to writing down the current shareholders' claim amounts to essentially bailing out the current shareholders. A better way is to pass a special law that allows capital reduction without shareholders' consent of essentially failed large-scale financial institutions. The banking system, which provides public-goods and is prone to systemic risk, can be treated differently from other industries which does not require public assistance. Once the reduction of equity capital is done, public capital injection will strengthen the balance sheets. A precommitment of a merger is not necessary, and it can take time to look for best buyers of a whole or part of the strengthened new bank.

Full information disclosure should be done for LTCB balance sheets if the public capital injection is sought, but it is reported that the government is reluctant to do it.

The top of the Financial Supervision Agency, Mr. Hino, responding a question by the opposition, stated that the LTCB is not insolvent, even before its due diligence was finished. This kind of prejudgment contributes to a general skepticism of regulatory agencies' independence. Public capital injection was carried out in March 1998, after "examinations" by the Financial Crisis Management Committee (FCMC) to make sure that the banks are solvent, viable, and healthy without problems in bank management. However, just after six months, one of the banks with capital injection, LTCB, is in trouble. This severely undermined the credibility of FCMC.

The LTCB case will be an important test case for implementing the right principles in dealing with nonperforming loans in essentially failed large-scale institutions.

VII. We hope prompt and decisive action of political leaders.