The reform of Japan’s policy-based lending institutions 
 

The deliberations on the reform of Japan’s policy finance institutions have reached the final stages. As a private member of the Council on Economic and Fiscal Policy pointed out during the debate, it is widely accepted that “the days of traditional policy finance are basically over,” and if policy finance institutions are to play a role at all, it is essential that this be limited to functions that the private sector cannot fulfil.   

So far, the focus of the deliberations has been on how many government-affiliated policy finance institutions there should be after the reorganization. But if the debate stops here, there will be insufficient consideration of what useful role they can still play, leading to the danger of half-measures in the curtailment of their scope. For example, there are strong concerns that even once the institutions are merged, unnecessary functions may in fact be retained.  

The following are two examples of the problems associated with the current policy finance system. First, not only are the policy finance institutions supported with large sums of taxpayers’ money; on top of that, they are also financially unstable. In fiscal 2004, the total amount of additional capital and subsidies for the eight government-affiliated policy finance institutions (excluding the Housing Loan Corporation) climbed to ¥373.7 billion. Second, because the government-affiliated policy finance institutions can lend funds at lower interest rates than private financial institutions thanks to the government support they receive, they undermine the business of private financial institutions. The interest rate charged by the policy finance institutions does not adequately reflect risk, leading to a distortion of interest rates in credit markets. Appropriate monitoring does not take place and among the firms which receive loans from the policy finance institutions are many that otherwise essentially would have to close down. In turn, as a result of such ailing companies’ staying in the market, the earnings of financially healthy companies are undermined.  

For this reason, the policy finance institutions should withdraw from fields in which they compete with the private sector and instead, once their transparency has been increased, devote themselves to areas in which they compliment the private sector and where the use of large amounts of taxpayers’ money can be justified.  

Areas where policy lenders can complement private lenders are limited to lending in those fields where private returns are low but the social return is extremely high. Loans with such a “social return” include, for example, loans to developing countries in the context of international co-operation where the benefit is spread thin and wide across the entire population; the nurture of new industries in which it is difficult for private enterprises to prosper but which offer a benefit for wider society; or investments in public projects in which there are few precedents on which to base an assessment of risk. In these instances, loans from private financial institutions will not be forthcoming even if an investment is desirable from a societal point of view. Consequently, there is justification for government institutions (and, in the final analysis, the taxpayer) to take on the risk, and this solution is preferable to the provision of subsidies to private-sector financial institutions to take on the risk where this is difficult to evaluate. However, in order for government-affiliated financial institutions to fulfil this function, they need intelligence gathering and monitoring abilities as well as financial expertise matching those of private-sector institutions.  

Among the issues that policy-based lending is supposed to address according to the private member’s bill put forward by the Council on Economic and Fiscal Policy, those that can be justified from the viewpoint of policy-based lending as complementing the private sector are infrastructure policy and international economic co-operation. However, strong doubts remain with regard to policy-lending objectives focusing on small and medium enterprises (SMEs), agriculture, forestry, and fisheries, and Okinawa put forward in the same proposal.  

Let’s have a closer look at policy-based lending to small and medium enterprises. The background to this debate is that in light of the role government-affiliated institutions played in providing lending to SMEs during the financial crisis a few years ago, it is thought that a safety net for a period of financial crisis should be maintained. However, when dealing with a financial crisis, the natural policy response for restoring the financial sector to health is to consolidate insolvent banks and provide support for those that are facing a temporary liquidity shortage. In the event that it take times to restore private-sector banks to financial health, it would be sufficient for the government to provide support or moderate government guarantees (taking the danger of moral hazard into account, a 100% guarantee would be undesirable) for private sector banks that lend to troubled small and medium enterprises. The point is that even if the support of SMEs in times of financial crisis is an important policy goal, there are ways to achieve this objective other than to rely on government-affiliated financial institutions. 

There may also be arguments that government-affiliated financial institutions should provide loans to small businesses that have just been established because private sector banks may be reluctant to provide loans as a result of information asymmetries regarding the trustworthiness of such newly-established businesses. But the information production capacity of government-related banks does not exceed that of private-sector ones and it is difficult to imagine that a government-related financial institution that has to spread its resources over the entire country is superior to private-sector banks with expertise in their particular region.  

Not only are most government-affiliated banks unnecessary; it should also be remembered that, as mentioned above, they have an adverse effect on the financial system. This is because their loan interest rates are determined by policy factors, so that it becomes difficult for private sector banks to charge interest rates that adequately take risk and the length of the loan period into account as they would in a fully competitive environment; as a result, government-affiliated bank lending, rather than providing any benefit, in fact obstructs lending by the private sector. What is more, once a government-affiliated bank has expanded its sphere, even if private sector banks develop the necessary financial and risk management techniques and could fill the gap, the government institution will find it difficult to contract again.  

At the time of the reform, it would be ideal if the government-affiliated banks disposed of the credit portfolios they currently hold by selling them on the market. This way, the reform of the government-related financial institutions would contribute to an enlargement of the credit market and subsequent loans to small and medium enterprises would be expedited. Moreover, following the example of the Housing Loan Corporation, which is one step ahead in the reform process, the government-affiliated banks, while acting as loan guarantors, could enter the market as buyers of private-sector bank loans, although this should only be a transitional measure until the market is fully established.  

In sum, institutions that compete with the private financial sector should be privatized if there is a prospect that they will be profitable; if they are unlikely to be profitable, they should be wound up. If the aim is to fund projects that yield a low private but a high social return, policy-based lending does have a value and institutions should be reformed by merging overlapping functions and simplifying structures.  

From the points raised above, the direction that the reform of each of the eight institutions should take can be easily derived:  

The Japan Bank for International Co-operation (JBIC) complements private financial sector institutions by providing finance related to high-risk energy projects, by co-operating with international organizations in the response to currency crises, and by providing loans to developing countries; in addition, the JBIC provides concessionary aid and shoulders functions that the private sector cannot fulfil and it should therefore continue to play these roles. However, it should reduce its financing directed at developed countries (such as trade finance). 

The Development Bank of Japan (DBJ) has shown achievements in the development of new financial techniques and could be privatized as an investment bank. However, should it continue as a policy-based lending institution, its role should be limited to fields such as high social-return loans or the development of markets, an activity which carries high externalities, and it should withdraw from fields in which it competes with the private sector. These two, the JBIC and the DBJ, are the only government-affiliated financial institutions that fulfil functions that compliment the private sector. The remaining six institutions are active in fields where they basically compete with the private sector. Even if it is appropriate for the government to pursue specific policies with regard to, say, SMEs, agriculture, forestry, and fishery, or the development of Okinawa, the role and organization of policy-based lending is highly problematic.  

Many of the activities of the National Life Finance Corporation and the Japan Finance Corporation for Small and Medium Enterprise overlap and the two institutions should be merged and then withdraw from the loans business and instead, for the time being, concentrate on credit guarantees and credit securitization. Once a functioning market has been established and the function of these two institutions has become obsolete, they should be closed down.  

As for the Shoko Chukin Bank, this can probably be privatized quite easily, because unlike other government-affiliated financial institutions it has not relied on any government subsidies,  

The Japan Finance Corporation for Municipal Enterprises should be wound up after an appropriate transitional period to allow for the development of a municipal bond market that can take its place.  

The Agriculture, Forestry and Fisheries Finance Corporation should be closed down as agricultural co-operatives and regional banks can easily fill its place.  

Similarly, the job of The Okinawa Development Finance Corporation can also be easily carried out by other financial institutions and it should be abolished. 
 

Takatoshi ITO (Tokyo University)

Masaya SAKURAGAWA (Keio University)

Kimie HARADA (Chuo University)

Takeo HOSHI (University of California, San Diego)

Kaoru HOSONO (Gakushuin University)

Nobuyoshi  YAMORI (Nagoya University)