Never-Ending Effort to Dispose of Non-Performing Loans

Koyo OZEKI (Managing Director, Merrill Lynch Nihon Securities Credit Research)

The Japanese government recently announced the result of the special inspection that had been conducted on major banks since last fall, triggered by the bankruptcy of Mycal. It was focused on 149 companies that were big borrowers (with the loan balance more than 10 billion yen each, and the total debt of 12.9 trillion yen as a whole) and had been undergoing drastic changes in their stock prices or outside ratings. According to the special inspection result, 71 companies whose total debt is 7.5 trillion yen have been reclassified into a lower category of borrowers. Among them, 34 companies with their total debt of 3.7 trillion yen are now placed below the category of "potentially bankrupt companies."

As a result, the loss due to the disposition of non-performing loans, amounting to 1.9 trillion yen, has been newly added, and the total amount of the non-performing loans that are to be disposed of by major banks is expected to be 7.8 trillion yen for the fiscal year 2002, ending in March 2003. How should we evaluate the result of this special inspection in the context of the non-performing loan problem for the Japanese economy as a whole?

One Third of Way Out

It may be a step forward to have inspected and reclassified loans for big borrowers and asked banks to dispose of additional loans by 1.9 trillion yen, as compared to the situation a year ago, when the financial authority only said that "loans for risky borrowers are not bad loans, and the remaining problem is the disposition of loans below the category of potentially bankrupt companies."

However, this should be regarded as only a small step upward from a very low level, where the government had not done anything proper about the non-performing problem since the injection of public funds in 1999 and it was forced to conduct the special inspection as a result of the bankruptcy of Mycal. There is a long way to go before Japan's non-performing loan problem is resolved for financial revival.

The problem is the limited scope of the loans inspected. The total amount of the loans inspected this time was 12.9 trillion yen, all made by main banks. Supposing the share of loans made by main banks is about 30%, the corresponding amount of loans made by all banks as a whole should be 3 times as large, that is about 40 trillion yen. This is approximately equal to the minimum amount of non-performing loans to be disposed of now. In this sense, we are yet one third of way out of the non-performing loans for big borrowers.

It seems that attention has been focused on risky loans for big borrowers in the last several months. But we must not forget that banks are likely to incur substantial losses due to the disposition of loans below the category of potentially bankrupt companies. This might well be 1.5 to 2 times as large as banks' annual net profits, according to the author's estimate.

If we are only one third of way out of the risky loan problem for large borrowers, it is clearly unrealistic to stick to the scenario that "the non-performing loan problem would be solved within 3 years (in the next two years) based on a flow of net profits." Even more importantly, the creditworthiness of small and medium-sized corporations is likely to continue deteriorating, as the economic environment will be changing in the future. Therefore, banks are required to secure the ability of credit offering and risk taking for the sake of corporate and financial revival by disposing of existing bad loans.

Periodic Occurrence of Financial Crises

Most banks are maintaining the basic position that their allowances for bad loans as well as their own capital reserves are adequate. Behind this position, there appears to be an implicit assumption that the non-performing loan problem could be solved within the next ten years." However, we cannot continue avoiding the problem. Without solving the non-performing loan problem, asset deflation will continue and financial crises are likely to occur periodically. Furthermore, the problem would become worse if interest rates increased due to fiscal deterioration.

The worst risk for the Japanese economy would be a spiral for higher interest rates and a worsening fiscal position, when a massive injection of public funds becomes necessary, possibly in the next few years. It should be realized that such a risk is increasing as time passes.

(Translation of the original Japanese article that appeared in the May 14, 2002 issue of "Economist" published by Mainichi Newspaper Co.)