Urging a Political Decision to Avoid the Japanese Financial Meltdown
By the Shadow Financial Regulatory Committee (Japan)*
September 8, 1998 (immediate release)
Contact numbers for this statement:
In the US: Takeo Hoshi. Graduate School of International Relations and
Pacific Studies, University of California, San Diego, 9500 Gilman Drive, La
Jolla, CA 92093-0519; Phone:(619)534-5018, Fax:(619)534-3939.
In Japan; Takatoshi Ito, Phone/FAX (home) 03-5724-5808.
1. The difference between the two proposals (draft bill in the Diet)-one by
the government-LDP (LDP plan, for short) and the other by the opposition
parties (Opposition plan, for short)-is not large. Some form of compromise
between the two without damaging the spirits of the both bills is possible
and highly desirable.
2. We propose a restructuring procedure that is consistent with an idea that
a big bank is "too big to close" rather than "to big to fail."
3. In order to avoid moral hazard, bank management should be replaced and
current shareholders equity claims should be written down, before any public
capital injection. A large-scale financial institution that needs public
capital injection must continue honoring all liabilities to avoid systemic
risk, while assets and liabilities are being winding down. A legislation
that would allow the regulatory agency to write down equity claim of an
essentially failing institution without the shareholders' meeting.
4. The Long-term Credit Bank (LTCB)'s shareholder claims should be written
down before the public capital injection. Precommitment of merger with the
Sumitomo Trust Bank may not be necessary or desirable.
5. Politicians should be decisive, prompt, and ready to make compromises.
* Mitsuhiro Fukao (Keio University), Chair; Kazuhito Ikeo (Keio University),
Takatoshi Ito (Hitotsubashi University), Mitsuru Iwamura (Waseda University),
Yuri Okina (Japan Research Institute), Hideki Kanda (University of Tokyo),
Yutaka Kosai (Japan Economic Research Center), Akiyoshi Horiuchi (University
of Tokyo), Takeo Hoshi (University of California, San Diego)
I. Common Objectives.
Many points are common in the LDP and the Opposition plans:
(1) All deposits should be protected.
(2) When a financial institution fails, public assistance can be used to
protect depositors and innocent third parties (other creditors and
borrowers).
(3) Managers and shareholders of a failed financial institution should be
held responsible for the failure.
(4) Borrowers who are truly solvent should be protected.
(5) Contagious failures of financial institutions should be avoided.
We support these points.
II. Differences are Small
Difference between the LDP and the Opposition plans is small.
The major differences are:
(1) Whether, and under what conditions, public money should be injected to a
financial institution that has not failed.
(2) How much information over balance sheets of financial institutions
(especially the ones that accept public money) should be disclosed to the
public.
(3) In the LDP proposal, a failed financial institution is first managed by
a "financial manager (receiver)" and then, unless it is immediately
purchased by another financial institution, transformed into a state-owned
bridge bank. In the Opposition plan, a failed financial institution is
immediately liquidated or nationalized without the interim period of state
management.
These points are less important than those that are common between the LDP
and Oppostion plans, and some form of compromise is possible and essential
for stability of the financial markets.
III. Principles of dealing with essentially failed large-scale banks
We propose the following principles that should be observed in restructuring
a big bank whose immediate liquidation may trigger a systemic risk. These
principles materialize spirits of both the LDP and Opposition plans:
(1) Reduction (write down) of current shareholders' equity prior to public
capital injection;
(2) Full information disclosure
(3) Protection of Depositors and (non-subordinated) creditors
(4) Consistency with Restructuring of the banking industry
(5) Credibility of Financial Examination and Supervision
These principles will be explained in detail in the next section. The
government has suggested that "a big bank cannot be failed," but without
specifying what is a "failure," the argument confuses the public debate. We
consider that any institution which requires public assistance can be deemed
"essentially failed" regardless of its status of solvency. There is a way to
deal with a large-scale financial institution without causing systemic risk.
IV. Principles for public capital injection
(Principle #1) No public capital injection without prior reduction (write
down) of equity capital
To prevent moral hazard, it is imperative to impose losses on shareholders
of failed financial institutions as well as its managers. We urge
politicians to pass a legislation that allows financial institutions can be
forced to reduce (write down) the equity capital without a special
resolution of shareholders meeting, creditors meeting, or a bankruptcy court
procedure. Also desirable is another legislation that makes claims of
subordinated debt holders to take losses for the institutions that receive
public capital injection, even a formal bankruptcy court procedure.
(Principle #2) Full Information Disclosure
To prevent ad hoc political intervention and to limit excessive discretion
(and forbearance) by the regulators, thorough disclosure of information is
necessary. Especially those financial institutions which ask for assistance
by public money should be required to reveal relevant information such as
the amount of classified loans, their assumed recovery values, identities of
large insolvent customers, and financial information on the related
companies (subsidiaries) under their control.
(Principle #3) Protection of all depositors and (non-subordinated) creditors
We are against the idea of "too big to fail," but we believe that a large-
scale financial institution can be "too big to close." Because a big bank
has so many and intricate financial transactions, it would take a
substantial amount of time to recover assets values without causing systemic
risk. It makes more sense to put an essentially failed big bank under
temporary government control and let it continue its operations, until it is
restructured, and sold to a healthy institution or liquidated.
(Principle #4) Consistency with restructuring of the Banking industry
Public assistance of banking sector must not hinder necessary structural
reform of the Japanese banking sector to recover its productivity and
efficiency. The Japanese economy has been in the state of overbanking
recently. Given that the traditional banking business would be eroded by
development of capital markets and globalization, amount of human and
capital resources dedicated to traditional banking business is expected to
decline. Public capital injection and restructuring of essentially failed
institutions should be consistent with this reality.
(Principle #5) Credibility of Financial Examination and Supervision
Financial supervision and regulatory agencies, which oversees restructuring
of failed banks (with a possibility of using public capital injection), must
be independent from political intervention and their code of conduct and
mandate should be clearly spelled out by set of established rules. All the
financial regulators, including Ministry of Finance, Bank of Japan, Deposit
Insurance Corporation, Financial Crisis Management Committee, and Financial
Supervisory Agency, seem to have failed to establish such credibility so far.
It is important to clarify the responsibility and mandate of each
regulatory authority and regulatory relationship among them. This is
important for establishing credibility.
V. Strengthening regulatory power
In order to implement "too big to close" bank following the principles
listed above, and to rescue the Japanese financial system from crisis, we
need a powerful financial regulation. For example, the regulator should be
able to limit the bank shareholders right to allow capital reduction without
a resolution at shareholders meeting. Since the regulatory power of the
supervision agencies are to be strengthened, its responsibilities are also
immensely important. Their independence has to be guaranteed by legislation,
and top regulators have to be experts and dedicated (as full time job, and
avoiding conflict of interest) on the subject.
VI. LTCB Problem.
The sticking in dealing with LTCB is whether to inject public capital prior
to its merger with the Sumitomo Trust Bank. The LDP insists that it is
necessary, and the Opposition insists that it should not be done. There is a
way to bridge the difference when the principles listed above are recognized
to be important.
The plan of LTCB to be merged with the Sumitomo Trust Bank, as it is
currently reported, does not seem to satisfy some of the principles listed
above. For example, the plan does not seem to require reduction of equity
capital of LTCB before the merger. The government seems to try using the
merger as an opportunity to effectively reduce LTCB's capital by setting a
tilted equity swap ratio. However, the Sumitomo Trust insists that balance
sheets should be cleaned before the merger, which requires public capital
injection. Then capital injection prior to writing down the current
shareholders' clam is planned, essentially bailing out the current
shareholders. This is wrong. The better way is to pass a special law that
allows capital reduction without shareholders' consent of essentially failed
large-scale financial institutions. The banking system, which provides
public-goods and is prone to systemic risk, can be treated differently from
other industries which does not require public assistance. Once the reduct
ion of equity capital is done, public capital injection will strengthen the
balance sheets. A precommitment of a merger is not necessary, and it can
take time to look for best buyers of a whole or part of the strengthened new
bank.
Full information disclosure should be done for LTCB balance sheets if the
public capital injection is sought, but it is reported that the government
is reluctant to do it.
The top of the Financial Supervision Agency, Mr. Hino, responding a question
by the opposition, stated that the LTCB is not insolvent, even before its
due diligence was finished. This kind of prejudgment contributes to a
general skepticism of regulatory agencies' independence. Public capital
injection was carried out in March 1998, after "examinations" by the
Financial Crisis Management Committee (FCMC) to make sure that the banks are
solvent, viable, and healthy without problems in bank management. However,
just after six months, one of the banks with capital injection, LTCB, is in
trouble. This severely undermined the credibility of FCMC.
The LTCB case will be an important test case for implementing correct
principles in dealing with nonperforming loans in essentially failed large-
scale institutions.
VII. We hope prompt and decisive action of political leaders.