In the post-war period, Japan faced a severe shortage of capital and weak financial infrastructure. World War II virtually wiped out the household sector’s financial assets. The priority of the US occupying force and the new Japanese government was to increase assets, which in turn could finance recovery of the real economy. The outcome was a highly segmented financial system, with strong regulatory control exerted by the Ministry of Finance (MoF), backed by the Bank of Japan. Domestic and foreign and short and long-term financial transactions were kept separate, interest rates regulated, and financial firms organised along functional lines. Table illustrates this high degree of functional segmentation. This arrangement fitted in with the keiretsu system. A keiretsu is a group of companies with cross-shareholdings and shared directorships which will normally include a bank, trust company, insurance firm and a major industrial concern such as steel, cars, property and construction. The bank supplies services to the other keiretsu members, including loans.
The MoF was the key regulator, through three MoF bureaux: Banking, Securities and International Finance.46 Responsibilities included all aspects of financial institution supervision: examination of financial firms, control of interest rates and products offered by firms, supervision of the deposit protection scheme, and setting the rules on activities to be undertaken by financial firms.
The MoF used regulatory guidance (combining the statutes with its own interpretation of the laws) to operate the financial system. Banks, in exchange for providing low interest
The Functional Segmentation of the Japanese Banking Sector, pre-Big Bang
loans to large industrial firms, were protected from foreign competition, and the highly segmented markets (see Table) limited domestic competition. In return, until 1995, there was an implicit guarantee that virtually any financial firm getting into trouble would be protected – a 100% safety net. MoF officials were often given jobs by banks when they retired – evidence of the cosy relationship between the MoF and regulated bankers.
The Bank of Japan (BJ) was responsible for the implementation of monetary policy, but was not independent. MoF officials exercised strong influence through its membership on the Bank’s policy board. The Bank and MoF conducted on-site inspections of banks in alternate years. The Bank of Japan also acted as banker for commercial banks and government, regulated the interbank market and was consulted about regulatory issues, though the MoF took all final decisions.
Functional segmentation and restrictions on international capital flows resulted in an excessive dependence on the banking sector compared to other major industrialised countries. In 1998, 60%of domestic corporate finance in Japan consisted of loans, compared to just over 10% in the USA. Capital markets were underdeveloped. Participation by foreign financial firms in the Japanese markets was also low compared to other financial centres, mainly because the Japanese believed their interests were best served if foreign firms were kept out. Token gestures were made, to avoid criticism from the world community. In 1997, there were 94 foreign financial firms, compared to 290 in NewYork, 533 in London and 560 in Frankfurt.
Japan’s Big Bang, 199647
Following the crash of Japan’s stock market in late 1989, Japan’s financial sector went into severe decline, so that by the beginning of the 21st century most Japanese banks were insolvent. In an attempt to revive the financial sector, ‘‘Big Bang’’ was announced in 1996. The programme of reforms was designed to fulfil two objectives. First, the financial sector was to be restructured, putting an end to functional segmentation. Second, to restore financial stability, the Financial Supervisory Agency and Financial Reconstruction Commission were established. The Bank of Japan was granted independence.
Big Bang was announced in November 1996 by Prime Minister Hashimito. The somewhat optimistic objective was to place Tokyo on a level playing field with New York and London by 2001. The package of reforms is based on three principles: FREE, FAIR and GLOBAL.
FREE: Free market principles were to apply to the financial sector. Integration of the banking, securities and insurance markets was encouraged. Financial products and prices were to be liberalised. Rules which prohibited banks from jointly engaging in short and long-term operations were to be abolished. Fees and commissions, especially on the stock market, would be liberalised.
FAIR: A transparent, fair financial market was to be created through the complete disclosure of information at all levels, including government, with clear rules on market operations. Investors were to be encouraged to take responsibility for their actions, but at the same time, new laws of investor (especially retail) protection were to be introduced.
GLOBAL: Tokyo was to become an international financial centre, raising Japan’s international profile. Accounting, legal, supervisory and tax procedures would be changed to meet global standards set by international organisations such as the Basel Committee and the International Organisation of Securities Commissions.
Space constraints prevent a detailed outline of the reforms; for more detail, see Heffernan (2001). The thrust of the reforms was to largely eliminate the segmented markets characteristic of the Japanese financial sector since the end of World War II. In its place is a form of ‘‘restricted’’49 universal banking. Using the financial holding company structure introduced in the United States, banks will be able to own separately capitalised securities firms and vice versa. Global expansion is largely unrestricted and foreign firms are given improved access to Japan’s financial markets. In addition, Japan is party to the key international agreements, such as Basel 1 and Basel 2. However, Japan’s interpretation of tier 1 and tier 2 capital means the ratios are not strictly comparable with those produced by other countries.
The combination of reform and financial difficulties caused a large number of mergers, even among the top banks. Table reports the top 5 Japanese banks (by tier 1 capital), together with a few key ratios. The banks listed did not exist a few years ago, and testify to the large amount of merger activity. These mergers will affect the keiretsu system – some of the banks which have merged belonged to different keiretsu (e.g. Sumitomo and Mitsui). Note the negative ROAs, and the high cost:income ratios, compared to other major countries. The regulatory system was also reformed. The MoF (given a new name, ‘‘Zaimisho’’), blamed for much of Japan’s financial malaise, had its responsibilities sharply curtailed. The opaque system of regulatory guidance was replaced with transparent rules. The Bank ofJapan Act, 1998 gave the Bank a large degree of autonomy, with a remit to focus on price stability. The Cabinet appoints the Governor, Vice-Governor and Policy Board, but it cannot dismiss them. The MoF is no longer a member of the Policy Board, though
Top Japanese Banks (by Tier 1 Capital) in 2003
representatives can express their opinions at meetings. In addition to maintaining price stability, the Bank of Japan, together with the Financial Services Authority, conducts bank examinations. The power of the Finance Minister to issue directives to the Bank of Japan has been revoked. However, the MoF has been left with responsibility for the yen’s stability. The Finance Minister also has the right to approve the Bank’s budget, and can require the Bank to make loans to troubled financial institutions.
After an interim arrangement, the Financial Services Agency (JFSA) was formed in 2001, through a merger of the Financial Reconstruction Commission and the Financial Supervisory Agency. It reports to the Prime Minister’s Office (not the MoF). The FSA both formulates policy and regulates the financial sector. As new institutions, establishing creditability is a major challenge for both the Bank of Japan and the Financial Services Agency.
Temporary changes in the deposit insurance scheme were also designed to restore financial stability. Established in 1971, the Deposit Insurance Commission (DIC) currently reports to the Financial Services Agency. The Deposit Insurance Act was amended in response to the large number of bank failures in 1998. Levies on banks’ deposits fund the DIC, but ¥17 trillion was injected into the fund to assist banks and allow for 100% deposit insurance coverage.
A temporary measure, it expired in March 2002, and reverted to the original scheme, that is, each depositor of a failed bank is paid a maximum of ¥10 million (plus interest). The only exception was liquid or settlement (used for direct debits, etc.) deposits, which earn no interest, where the 100% deposit insurance would not expire until March 2003. However, in the period leading up to March 2002, there was a notable transfer of funds to protected deposits and gold. In September 2002, fearing new bank runs, Japan’s FSA announced the 100% guarantee would continue to apply to all liquid deposits until April 2005. The DIC can draw on a special fund for banks if failure is deemed to threaten overall financial/economic stability at a local or national level. A Conference for Financial Crises (chaired by the Prime Minister) will decide which banks pose a systemic risk. However, it is often very difficult to distinguish between illiquid and insolvent banks, and a weak economy will make the job tougher.
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