Japan's Financial Functions Stabilization Act

Financial deregulation in Japan began in the early 1970s (Kanaya and Woo 2000; Nakaso 2001). However, uneven deregulation of similar activities by different types of financial entities had created opportunities for regulatory arbitrage (Kanaya and Woo 2000). Under the informal “convoy system,” the Ministry of Finance and Bank of Japan relied on stronger banks to bail out weaker banks (Kanaya and Woo 2000; Nakaso 2001). The convoy system created an implicit assumption among market participants that the banking system was “fail-safe” as banks expected the Ministry of Finance to offer solutions to problems banks faced. Banks supported the system because it facilitated mergers that allowed stronger banks to expand their branches, which had previously been a highly regulated activity (Nakaso 2001).

In 1986, the Diet, the legislative body of Japan, revised the Deposit Insurance Act to create a formal safety net. The new law provided the Deposit Insurance Corporation of Japan (DICJ) two policy options to address a failed bank: 1) liquidating failed banks, with each depositor protected up to ¥10 million; 2) transferring the business of a failed bank to an assuming bank. At the time, officials believed the DICJ would draw upon the new fund only in the rare event of a small-bank failure. In its first year, the DICJ had an insurance fund of only ¥300 billion, which was far less than would be needed to rescue a failing large bank (Nakaso 2001). At the time, the size of deposits for the top 10 banks in the Japanese financial system was ¥264 trillion^FNConversion based on December 31, 1987, dollar-yen exchange rate. Source: Board of Governors of the Federal Reserve System (U.S.), Japan/U.S. Foreign Exchange Rate [DEXJPUS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DEXJPUS, November 15, 2019. (Nash 1988). This deposit insurance system’s small size and inflexibility eventually made it inadequate for the coming financial crisis of the 1990s (Nakaso 2001).

When Japanese stock market and real estate prices collapsed in 1990-92, the initial systemic implications appeared limited. The few sporadic financial failures were of limited scope and systemic importance (Nakaso 2001). But over the next decade, Japan would slip into a period of economic stagnation where real GDP growth fell below 1% for ten years, as seen in Figure 1 (Lipscy and Takinami 2013).

Source: Lipscy and Takinami 2013, 328.

Officials were aware at this point that major banks like Nippon Credit Bank were transferring bad loans to paper companies to reduce their own balance-sheet exposure, but allowed such behavior to continue as the existing infrastructure permitted funneling bad debt—a practice known as tobashi that was controversial amongst finance ministry officials. By avoiding the liquidation of bad debt through this funneling behavior, banks never realized the bad debt at market price, leading to inflated asset values on bank balance sheets (Amyx 2006).

In October 1994, two months before the failures of Tokyo Kyowa and Anzen, two urban credit cooperatives, the Governor of the Bank of Japan, Yasushi Mieno, gave a speech remarking, “It is not the business of the central bank to save all financial institutions from failure. On the contrary, failure of an institution that has reasons to fail is even necessary from the viewpoint of nurturing a sound financial system” (Nakaso 2001). The Ministry of Finance also faced competing interests—given authority of both fiscal policy and financial regulation, the Ministry began to prioritize “budgets over banks,” where the use of public funds contradicted the balanced budgetary principles in the short term (Amyx 2006).

At the time, capital requirements for domestic Japanese banks were weaker than international standards. Japanese banks were encouraged to meet Basel I capital standards but received no formal penalties for noncompliance, as these standards were seen more as a managerial guidance (Allen, Chakraborty, and Watanabe 2009).

The failure of Tokyo Kyowa and Anzen in December 1994 tested the government’s infrastructure for dealing with unsound financial institutions. No stronger financial institution was willing to take them over. Also, losses exceeded the amount that the DICJ was authorized to provide to protect insured depositors. On December 9, the BOJ established a new bank to assume the businesses of the two institutions, wiping out existing shareholders, and removing the management of the two institutions. The new bank, Tokyo Kyoudou Bank (TKB), was capitalized with ¥40 billion, of which the BOJ subscribed ¥20 billion and private financial institutions subscribed ¥20 billion. Private financial institutions also extended low-interest loans to the new bank. Virtually all Japanese financial institutions participated, providing capital and loans. The DICJ provided funds to protect insured depositors. However, the Bank of Japan’s role was controversial. Although the law allowed the central bank to provide risk capital to banks in its function as lender of last resort, it hadn’t done so since the 1960s (Nakaso 2001).

Private financial institutions were also increasingly reluctant to contribute to the convoy system, worrying about the impact on their own profitability and reputations (Nakaso 2001). Deregulation had also made it easier for banks to expand without facilitated mergers under the convoy system. In 1994, banks, for the first time, outright refused to participate in these rescues. In 1995, following another failure by a major bank, Moody’s changed its ratings criteria so that it would not take into consideration the possibility of a government-organized rescue; in this new system, Japanese banks received an average rating of “D” (Amyx 2006).

At this point, there was little room for the BOJ to ease monetary policy due to already low discount rates. As the state of the economy deteriorated, the BOJ began reducing interest rates rapidly, dropping the overnight lending rate from 6% in 1990 to 1% by 1995, shown in Figure 2 below (Lipscy and Takinami 2013). These low rates meant that from 1995 onwards, interest income for Japanese savers dropped by approximately ¥1 trillion yen per year (Amyx 2006). The central bank also was reluctant to lower rates further in fear of increasing inflation, even in the midst of a deflationary environment (Lipscy and Takinami 2013).

Source: International Monetary Fund.

In this environment with little room for monetary policy stimulus, as well as limitations on deposit insurance, jusen trouble emerged, beginning in 1993 and reaching full scale by 1995. Jusen companies—non-bank lenders founded by banks and other financial institutions to make housing and real estate development loans—experienced massive losses of ¥6.4 trillion. After an intense debate in the Japanese Diet (the legislative body of Japan), the Diet passed the first publicly funded package to address the banking problem, allocating losses to founder banks, lender banks, agricultural financial institution, and public funding (Nakaso 2001). The usage of taxpayer funding to cover the losses of unviable, non-depository financial institutions met public outcry; an Asahi poll found 87% of the public opposed the jusen bailout (Lipscy and Takinami 2013; Nakaso 2001). As a result, the Minister of Finance promised the Diet that no further public-funded injections would occur except for the jusen injections (Lipscy and Takinami 2013).

Banks were also reluctant to take government funding through public injection. Not only would injections of public funding increase scrutiny of bank balance sheets, they would also call into question management practices and corporate salaries, and allow political intrusion into bank management decisions. In addition, issuance of new shares to the government would dilute the value of existing shares primarily held by other financial institutions and corporations (Amyx 2006).

By 1997, as the situation grew worse, with the collapse of four banks in succession, the BOJ acted as lender of last resort on an unprecedented scale (Nakaso 2001). In December 1997, the ruling Liberal Democratic Party (LDP) announced Japan’s first recapitalization for banks in the post-war era (Japan Times 1997b).

The Diet paired the intended recapitalization under the Financial Functions Stabilization Act with an amendment to the Deposit Insurance Act increasing depositor protection. The act allocated ¥17 trillion for depositor protection and ¥13 trillion for recapitalization for undercapitalized banks (Japan Times 1998i). The FFSA was a temporary measure intended to utilize public funding for capital injections to increase stability in the Japanese financial system (Nakaso 2001).

The day after the government announced the recapitalization program, the Nikkei average jumped 2.5% in a show of investor relief (Japan Times 1997c). However, some ratings agencies continued to downgrade major Japanese banks, with Standard & Poor’s downgrades occurring on December 25, one day after the announcement by the LDP (Japan Times 1997c). Moody’s kept ratings low, even after banks began applications for recapitalization in March 1998 (Japan Times 1998k).

After finalizing the banking bills, Prime Minister Ryutaro Hashimoto’s Cabinet submitted the finalized version of two bills—one for increased depositor protection and one for recapitalization—to the Diet on January 19, 1998 (Japan Times 1998e). To encourage the passage of the bills, Prime Minister Hashimoto unconventionally visited the Diet to give a series of speeches on the necessity of the financial system stability measures (Japan Times 1998a; Japan Times 1998b; Japan Times 1998d; Japan Times 1998f). After passing the Lower House on February 7, the bills passed the Upper House on February 16 and were formally enacted into law (Japan Times 1998h; Japan Times 1998i).

Before the recapitalization bill passed, the Japanese government worked to encourage banks to participate in the program, hoping that the vocal participation of stronger banks would encourage weaker rivals to participate as well (Japan Times 1998c). Several banks applied for the funding simultaneously on March 5, 1998 (Japan Times 1998k).

The Financial Crisis Management Committee (FCMC) oversaw the recapitalization. It consisted of seven members, including three from the private sector, the Minister of Finance, the Commissioner of the Financial Supervisory Agency (FSA), the President of the Bank of Japan, and the President of the DICJ. The Cabinet appointed members of the committee with consent from both houses of the Diet (Financial Functions Stabilization Act 1998). Dr. Yoko Sazanami, an academic at Keio University in Japan, chaired the committee (Madden and Dimand 2018). The FCMC, part of the DICJ, was responsible for identifying banks in need of capital injections and determining the amount and terms of such injections (Madden and Dimand 2018; Nakaso 2001). The Cabinet was responsible for terminating the operation of the FCMC (Financial Functions Stabilization Act 1998).

The DICJ was responsible for the asset management operations of the capital injections specified by the FCMC (Financial Functions Stabilization Act 1998). The DICJ purchased preferred shares or subordinated bonds from the financial institutions that applied for capital under the recapitalization scheme (DICJ 2020; Financial Functions Stabilization Act 1998). The Crisis Management Account, an account set up for purchases under the FFSA, held the DICJ purchases (DICJ n.d.).

No banks were ineligible under the FFSA; while there was some debate about making the injections compulsory for certain banks, the idea was ultimately abandoned (Financial Functions Stabilization Act 1998; Nakaso 2001). Three non-bank financial institutions, all cooperatives, were also eligible, referred to by name in the law: Norinchukin Bank^FNNorinchunkin Bank is a cooperative bank for agricultural, fishing, and forestry cooperatives in Japan.; the Agricultural Cooperative Association; and the Federation of Fisheries Cooperative Associations (Financial Functions Stabilization Act 1998).

Banks requesting funding applied through the Chairman of the Financial Supervisory Agency (FSA), Japan’s bank regulator, who then applied on their behalf. The FCMC itself did not have supervisory power and could not look at any detailed balance sheet or supervisory information on the applicant banks (Financial Functions Stabilization Act 1998; Nakaso 2001). These banks would be required to submit management improvement plans through the FSA. In the plans, the banks would describe how they would improve management and operations, and secure assets. After the FCMC approved an application, it would go to the Prime Minister’s Cabinet for approval, by either the Prime Minister or the Minister of Finance. Once approved, the DICJ would purchase preferred shares, subordinated debt, or subordinated loans (Financial Functions Stabilization Act 1998).

In March 1998, 21 institutions applied for capital injections. Figure 3 below shows a table of the applications for capital made public.

The total application size amounted to close to ¥2 trillion. Within a week, the FCMC approved all 21 banks for the capital injections. However, two banks that had applied for subordinated debt and loans received less than requested, as the FCMC believed the use of such lower-quality capital would not sufficiently boost their capital adequacy ratios (Japan Times 1998l). In March 1998, ¥1.8 trillion was injected into 21 banks, averaging 1.9% of risk-weighted assets (DICJ 2020; Giannetti and Simonov 2013). Every bank eventually repurchased the shares and subordinated debts sold to the DICJ under this program, as shown in Figures 4 and 5 below.