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April 10, 2006

Public Lenders Need Tough Oversight

Mitsuhiro FUKAO (President of Japan Center for Economic Research)

Five financial institutions to be merged into entity on commercial bank scale

Reform of public-sector lending is a top policy priority for the government of Prime Minister Junichiro Koizumi along with the privatization of postal services. The postal savings system and government financial institutions are closely linked to form huge public lending machinery. Downsizing the bloated public lending requires overhauling both.

Government lending institutions finance their loans with funds borrowed from a special account that receives money from postal savings, postal life insurance and public pensions and also with funds raised by issuing government-guaranteed debentures.

There public lenders raise funds at low cost and provide financing mainly to home buyers and businesses at relatively low interest rates.

On the surface of things, none of the nine government institutions lost money in fiscal 2004. But their finances are supported by massive government subsidies and investments.

The government provides financial support to these lenders almost regularly to cover their losses and subsidize interest. Without the subsidies, five of the nine institutions would have got into the red in fiscal 2004.

The public lenders also receive capital and interest-free loans from the government's general and special accounts. If the government had invested the money in private businesses, it would have produced dividends, capital gains and tax revenues. These lost profits resent the total opportunity cost of providing capital and interest-free loans to the public lenders.

Opportunity Cost

Cost Chart

In calculating the opportunity cost, I assumed that the cost-free money provided to these institutions would have produced at least a return equivalent to the subscription yield on government bonds if invested in private businesses.

I also assumed that the businesses would have paid corporate taxes at a rate of 40%. The total of the opportunity cost and the subsidies is the total fiscal burden on the government.

In the past 10 years, the government's annual financial burden of operating these institutions averaged about 1 trillion yen ($8.6 billion). The subsidies accounted for 70% of the total, with the opportunity cost responsible for the remaining 30%.

The Development Bank of Japan (DBJ) and the Japan Bank for International Cooperation (JBIC) pay part of their profits into the state treasury, while the Shoko Chukin Bank pays corporate and other taxes. But the annual payments by these three institutions amounted to only 20-50 billion yen.

The particularly costly institutions were the Housing Loan Corp., the yen loan operations of the JBIC, the DBJ and the Agriculture, Forestry and Fisheries Finance Corp.

Privatization route

For public lending reform, the government has decided to privatize the DBJ and the Shoko Chukin Bank, scrap the Japan Finance Corp. for Municipal Enterprises, and integrate the remaining five institutions and the international finance operations of the JBIC into a new institution.

The planned privatization of the DBJ and the Shoko Chukin Bank will inevitably increase their financial costs. Currently, the fiscal investment bonds issued by the DBJ are given the highest credit rating of AAA by Rating and Investment Information.

Thanks to massive capital injections by the government, the DBJ's capital ratio stands at a healthy 13.9%, and the quality of its capital is good. Therefore, I presume that the bank's credit rating after the privatization will be AA, higher than the A+ rating given to Bank of Tokyo-Mitsubishi UFJ.

Assuming that the DBJ will not accept deposits and raise funds only by issuing bonds even after the privatization, the expected downgrade would increase the bank's financing cost by 14.7 billion yen.

The bank will also have to pay 39.1 billion yen in corporate taxes. There two cost factors will reduce the bank's net profit by half, but will not cause the bank to fall into the red.

Similarly, the Shoko Chukin Bank will face a rise in the financing cost due to a downgrade of its credit rating. If the bank's rating is lowered to A3 from the current A2 by Moody's Investors Service, the financing cost will climb by 29.9 billion yen. This, combined with other cost increases, would push the bank into the red.

If the government fully privatizes the Shoko Chukin Bank while maintaining its present financing operations, the institution should be trimmed down substantially.

But if the Shoko Chukin Bank closes all of its overseas branches and specializes in domestic operations, its minimum capital ratio required under regulations of the International Bank for Settlements will go down from 8% to 4%.

In view of the Shoko Chukin Bank's low profitability, its market capitalization, if privatized, is likely to drop far below the capital the bank currently possesses. In other words, the market value of the Shoko Chukin Bank will be smaller than its book value.

In order to attain the level of shareholders' return on equity as expected of a fully privatized entity, the Shoko Chukin Bank should first of all try to raise lending rates offered to borrowers and reduce dividends it pays to the government and other financial contributors.

The Shoko Chukin Bank is jointly owned by the government and cooperatives of small and medium-size companies. The bank pays out dividends only to the cooperatives. The shares held by the government should be switched to preferred shares, which do not carry voting rights, to weaken the government's involvement in management.

The new public lender to be created through a merger of the five institutions will have over 30 trillion yen in loans outstanding, according to the figures as of the end of fiscal 2004. That is an amount rivaling the lending by a leading commercial bank.

But the new institution will be required to stop lending to certain types of borrowers in order to avoid competition with private players. That will whittle down the total of its loans outstanding by 27%.

During the past five years, the five institutions combined received some 136.8 billion yen in government subsidies on average a year and eked out a small profit. Without the financial support, they would have reported an average loss of 113.9 billion yen. Cutting back on profitable lending would increase the loss by 60 billion yen, forcing the government to boost its subsidies by a corresponding account.

Subsidy reduction

In order to pare down the subsidies to 50% of the average in the past five years, the new institution would have to cut losses from nonperforming loans by 20% and halve operating cost.

The situation clearly demands that the new institution be refashioned into a more efficient entity through the adoption of a system for corporate governance based on such standard schemes as management and audit committee. The management committee should play the corporate role of a board of directors.

As a means to enhance public oversight over the institution, Diet members should be given the right to sue the members of the management committee and the directors on behalf of the nation's taxpayers. When the government's capital or subsidies are used for purposes inconsistent with the predetermined policy objectives, Diet members would be able to file a damages suit against senior executives.

(Originally appeared in the March 27, 2006 issue of The Nikkei Weekly, reproduced here with permission.)

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