Japan's Financial System in Need of Radical Surgery

Toshihiko FUKUI (Chairman, Fujitsu Research Institute)

Drastic Steps to Revive Banking Sector

The issue of how to deal with North Korea has drawn increased international attention since Prime Minister Junichiro Koizumi and North Korean leader Kim Jong-il held an historic summit in September, 2002.

While the September 2001 terrorist attacks on the U.S. are said to have transformed the world, efforts are being made to establish a new system for global governance. Koizumi also appears to be taking action in accordance with such worldwide trends.

Japan faces a formidable challenge in reviving its economy, which remains a significant presence on the international scene. Since the U.S. has yet to recover from the collapse of the information technology bubble, Japan cannot count on the world's largest economy to generate stimulus, and must press ahead with structural reforms to defeat deflation. It is crucial to make vigorous use of market forces and allocate economic resources in an efficient way that creates new value. In other words, the economic metabolism has to be revitalized.

In any such effort, three kinds of reform must be undertaken in the financial sector.

First, private financial institutions must regain their ability to take risks. Unless excess banking capacity, or "overbanking," is eliminated and an environment readied for the introduction of a cap in government protection of deposits, financial institutions will be unable to play a key role in resource allocation.

Second, the postal savings and insurance system needs to be reformed. Government-affiliated financial institutions that fund their operations form the vast pool of postal savings have played an extensive role in the funding business, which has led to inefficient allocation of resources outside market mechanisms, and that urgently needs to be rectified.

A government panel dedicated to postal reform issues has presented three sets of recommendations: 1) have a special public company take over postal operations; 2) privatize the mail delivery service, postal savings and insurance operations; and 3) abolish the postal savings and insurance businesses and privatize the remaining operations.

The first option seems out of the question and the Koizumi government should opt for the third measure.

If the government decides on the second option, efforts should be made to ensure that the resulting effects are similar to those generated by the third option.

Third, government-affiliated financial institutions have to be radically restructured. Past efforts to restructure government entities simply merged them in order to reduce their total number. This time public financial institutions should be categorized according to function and how they can achieve specific financial policy goals, and similar bodies need to be grouped together.

There are three objectives to public finance, namely 1) to provide supportive function for the total financial system; 2) help reduce interest payments of corporate and individual borrowers; and 3) provide loans. The third function does not necessarily have to be carried out by public institutions and it seems possible to transfer it to the private sector. Such a measure would simplify the public financial sector enormously.

It remains to be seen what kind of program the new Koizumi cabinet will draw up to revive the banking sector. The government should come up with bold measures to get banks, whose operations have become quite defensive, to play an active role in the market instead of withdrawing from further activity.

In reviewing their outstanding loans to companies, banks should focus on their future relationship with corporate borrowers rather than their past dealings. In dealing with troubled borrowers, banks should act in accordance with the guidelines on creditor-led restructuring, which were set by the Japanese Bankers Association and Japan Business Federation (Nippon Keidanren) last year, instead of offering overly generous debt waivers.

Independent Action

The banking industry should not let the issue of deflation deter it from addressing the issue of overbanking. Banks have to revamp their business models to survive an expected shakeout and they have to take such action independently.

It is desirable that new managers, who are capable of implementing viable business models, should be appointed to top jobs at banks and that the banks should be regain a secure footing in terms of their capital.

While the capital-adequacy ratios of most major banks appear to be at sufficient levels, critics argue that the ratios are inflated by tax-deferred accounting.

Personally, I believe that it is necessary to inject public money into banks. It should be noted, however, that the last time public funds were pumped into banks, the recipient institutions considered the transfusions to be a kind of loan and have become reluctant to take new risks.

So the next time it injects taxpayers money into banks, the government should make it clear that the money is capital and not a loan. It must also have the banks make the final decision about whether to accept the funds or not.

In urging bank management to take responsibility for their institutions' financial mess, the government should take a cool-headed and rational approach.

(This article originally appeared in the October 28, 2002, issue of The Nikkei Weekly, posted here with the permission of the author and the publisher.)