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Commentary (October 28, 2004)

Postwar Financial Systems Fading Fast

Masahiko ISHIZUKA (Counselor, Foreign Press Center/Japan)

This month, two events of major significance in Japan's financial history have taken place, signaling the demise of old systems and hopefully the start of a new era. One is the filing of a criminal complaint against UFJ Bank; the other is the decision to bring the rehabilitation of the near-bankrupt supermarket giant Daiei Inc. under the auspices of the governmental Industrial Revitalization Corp. of Japan.

On the surface, the two events do not look related, except that UFJ Bank is a common factor, but in the end they show that the once-successful, uniquely Japanese systems that supported postwar economic development have ceased to be workable, leaving lingering impacts.

UFJ Bank, one of Japan's four so-called megabanks, was prosecuted by the Tokyo District Prosecutors' Office at the request of the Financial Services Agency on charges of covering up financial data with the intention to make the bank's bad loans smaller than they actually were during inspection by FSA regulators last year.

Technically, the filing of the complaint meant that the FSA simply complied with the law when inspectors found wrongdoing at the bank, but prosecution was regarded as something unusual in the history of Japan's banking administration. It marked a departure from the old relationship between regulators and banks, or the whole system of banking administration.

The present system strikes a contrast with the old days when the Ministry of Finance was all-powerful, holding financial institutions under iron-clad control through meticulous regulations and unchallengeable authority. Banks had little freedom in setting interest rates, offering new financial products or opening banking offices, to give a few examples.

In return, banks were guaranteed protection from competition from each other and from outside; any trouble would be taken care of by the authorities, which aimed not to let any institution fail. Stability of the financial system was the name of the game and all important. Under such a system, the relationship between regulators and banks were incestuous. Regulators never brought into open banks' wrongdoings, as authorities were supposed never to make mistakes. If a bank went wrong, it meant supervision by the bureaucrats was inadequate.

This utopian world was shattered when several major banks and a host of minor institutions collapsed during the 1990s. That was something inconceivable when the Ministry of Finance was in full control of the banks. The ministry's authority was eroded, with the supervisory responsibility for banking administration transferred to the independent FSA, attached to the Cabinet Office.

Death symbol

The fate of the deeply indebted, near bankrupt supermarket giant Daiei, on the other hand, is symbolic of the death of the unique "main bank" system that characterized and supported postwar industrial development in Japan. Under the system, one bank assumed primary responsibility for the governance and survival of a particular customer firm; in case of trouble at the company, this "main bank" went to its rescue at the bank's own expense. The system is a legacy of the wartime system where banks were assigned to particular manufacturers to ensure production of goods needed for the war. It worked well in the postwar period as well.

But the system went awry during the post-bubble economic malaise. The main banks that had lent massively to their protege firms during the bubble years found it difficult to withdraw support when those corporations suffered from the slump and were unable to repay the loans. Banks kept lending, only to see bad loans snowball, while borrower corporations staggered under heavy debt burdens. That was the true nature of the bad-loan crisis that threatened the stability of the nation's financial system and plagued the economy as a whole for a prolonged period.

Daiei, for which UFJ Bank is the main bank owning 400 billion yen ($3.7 billion) in nonperforming loans to the company, is a symbol of the dysfunction of the main bank system. UFJ, together with other major lenders - Sumitomo Mitsui Banking Corp. and Mizuho Corporate Bank - have repeatedly provided assistance to Daiei, amounting to more than 600 billion yen in the form of debt forgiving, without seeing a turnaround of Daiei, which seemed continuing only on a life-support system. There are numerous similar cases, if on a lesser scale.

When Daiei asked for another 400 billion yen in debt forgiveness by the banks, they insisted on having the IRCJ involved in the rehabilitation, despite the bitter opposition of Daiei, so that radical restructuring of the company will be ensured and its bad-loan problem resolved once and for all. After bitter fighting, Daiei caved in, to the relief of the banks and the FSA, which hopes to have bad loans at major banks halved by the end of next March, thus putting an end to the bad-loan issue.

Japan has long concentrated on the so-called indirect financing system, in which banks play an overwhelming role in corporate finance, as opposed to direct financing, in which the equity markets are the major source of funds. Many argue that direct financing should be promoted by channeling money, particularly personal financial assets, a majority of which are held in bank deposits, to equity markets, but the shift is slow thanks to the underdevelopment of equity markets in terms of their appeal to individual investors and to people's persistent orientation toward bank deposits.

The slow pace of change is hardly surprising, given that the postwar system has been heavily geared to indirect financing that gave priority to banks under the control of the Ministry of Finance. It belies Japan's persistent orientation toward a centrally controlled economic system where bureaucrats exercise power. The main bank system and the incestuous relationship between bureaucrats and financial institutions supported that orientation. Had equity markets been more developed, Japan would not have suffered so heavily from the bad-loan problems and the ensuing banking crises.

(Originally appeared in the October 25, 2004 issue of The Nikkei Weekly, reproduced here with permission.)

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