CREDIT RISK DIVERSIFICATION AS AN INCENTIVE FOR JAPANESE BANK MERGERS.

Author:Saardchom, Narumon
Position:Report - Statistical data
 
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BANKING CRISIS AND FINANCIAL DEREGULATION IN JAPAN

After World War II, banks in Japan had been heavily regulated by the Ministry of Finance. Interest rates, scope of business and foreign exchange were strictly regulated. As a result, competition was very limited and customers viewed banks indifferent from each other. Under the strict regulated system, banks are fully guaranteed by the Ministry of Finance. That is, banks can never fail under this system. The system proved itself to be quite efficient in building Japan after World War II as evidence reveals that the there were no major bank failures after the World War II up until around mid-1994.

Japan started deregulated its financial system in 1970s. The deregulation and liberalization were built around the motivation to make Japan a major world financial center. However, transforming Japanese financial system in to the US-style system is not an easy process given existing cultures and tradition of Japanese financial system. One unique characteristic of Japanese financial system before deregulation in 1970s is the low level of consumer credit. Young workers had to save to build the house given such scarce consumer financing. Overall saving rate of Japanese population was thus higher than that of most developed countries. On the other hand, firms in the real sector were deeply in debt because the system encourages real sector corporations to heavily borrow with the main objective of injecting the economy with high level of investment.

The ratio of the financial liabilities of the real sectors to total Gross National Product (GNP) has been rapidly increasing after World War II through the financial deregulation period. Japanese banks were treated as an intermediary that channels surplus household saving to industrial sectors. Therefore, Japanese banks acted more like providers of public financial services than competitive private sector intermediaries. Given such uniqueness of Japanese financial system, the authority decided to move with the financial reform policy by using a stepwise basis. Since the enforcement of the Financial System Reform Law of 1992 in April 1993, banks and other depository institutions are allowed to compete with securities firms via subsidiaries.

The deposit insurance system was established in 1971 to act as a safety net for banking system in Japan. The deposit insurance law was later revised in 1986 and enacted in March 1987. It specified that the Deposit Insurance Corporation (DIC) can deal with failed banks under two options: liquidation and financial assistance. The insurance amount under the liquidation option is up to ten million yen for each depositor. The loss amount above this upper limit might be recovered depending on the remaining value of the failed bank. Under the financial assistance option, the business of a failed bank would be transferred to an assuming bank. The DIC also transfers fund to an assuming bank as a financial assistance provision. Before the financial crisis, the insurance fund hold by the DIC was only 300 million yen, which was far too small compared to the actual deposit amount of banking system in Japan.

Japan began to experience major bank failures after mid-1994. In December 1994, two urban credit cooperatives; Tokyo Kyowa and Anzen, went bankrupt with a combined deposit of 210 billion yen. To avoid bank runs, the Ministry of Finance and the Bank of Japan decided to resolve the problem of these two failed banks by choosing financial assistance option, but there was no financial institution willing to be an assuming bank. As a consequence, the new bank named Tokyo Kyoudou Bank (TKB) was established to assume the assets and deposits of the two failed credit cooperatives.

In 1995, Daiwa Bank, an internationally active city bank was ordered by the US regulators to close all its operations in the US market. In that same year, seven Junsen companies or housing loan corporations, non-bank institutions providing heavy lending to real estate developers, also went bankrupt, with the estimated total loss of 6,410 billion yen. In 1997, two major banks; Nippon Credit Bank and Hokkaido Takushoku Bank, had become insolvent. The contagion effects continued to grow among financial institutions in Japan. In fact, during the month of November 1997, major financial institutions in western Japan became insolvent almost on a weekly basis. These failed financial institutions include Sanyo Securities, Hokkaido Takushoku Bank, Yamaichi Securities and Tokuyo City Bank.

In 1998, Long Term Credit Bank of Japan and Nippon Credit Bank, two of the three long-term credit banks, had become bankrupt in October and December, respectively. This is the largest bank failure in Japan. The banks were nationalized by the public funds with the total amount of 60 trillion yen, more than 12% of GDP. The Financial Reconstruction Committee (FRC) sold the nationalized Nippon Credit Bank to a consortium comprising three Japanese companies: Soft Bank, Orix and Tokyo Marine and Fire Insurance, in September 2000. The new bank was later named Aozora Bank. In March 2000, Long-Term Credit bank was sold to an international group led by US based Ripplewood Holdings. This is the first time in the history that a Japanese bank is owned by a foreign firm. With new management and services, Ripplewood Holdings renamed the bank to Shinsei Bank in June 2000. In February, 2004, the IPOs of Shinsei Bank is held. Shinsei Bank later exchanged its long-term credit banking license for a standard commercial banking license.

INCENTIVES FOR CONSOLIDATIONS

After the financial crisis during 1990s, Japanese financial system has undergone a credit crunch period, during which time bank loans show negative growth rate until 2000. The Japanese financial system has also undergone a major structural change and consolidation. This is partly due to the consequences of deregulation and internationalization in the mid- 1970s. Ever since, several bank mergers and acquisitions have taken place as a response to an increasing competition from abroad. The government also encouraged the mergers of weakened banks and the purchase of nationalized insolvent bank.

The financial reform was also necessary due to the collapse of the bubble economy, during which time most banks in Japan faced with increasing amount of bad debts and relatively poor profitability. The declining real estate prices during the financial crisis period contributed to huge amount of NPLs that almost all financial institutions experienced. Since the bursting of bubble economy in 1991, the land prices started to decline and continued to decline for 15 consecutive years (1). Moreover, liquidation of NPLs through securitization was not made possible until 1998. Even that so, the liquidation of NPLs worsened the losses to banks because NPLs must be sold at extremely discounted prices. Bad debt experiences have influenced banks to change their lending behaviors by taking into account risk assessment process more stringently when evaluating borrowers. Meanwhile, the regulators began to apply quantitative method to evaluate and monitor credit risk or expected default probability of each financial institution. The aggregated credit risk measure at the industry level can be used to reflect the overall stability of the financial system and assess the effectiveness of the government policy on financial system.

The return on assets at major Japanese banks averaged -0.1% during the year 1993 to 1998, compared to an average of 1.2% for the 22 largest US banks (Drake & Hall, 2000). To improve profitability, cost saving through economies of scale must be achieved. Merger and acquisition were viewed as a way to achieve economies of scale and improve profitability. Merger could also enhance the bank's ability to write off non-performing loans. Up to 2004, ten leading banks have merged to create five mega banks, which include Mizuho Financial Group, UFJ Financial Group, Sumitomo Mitsui Financial Group, Tokyo-Mitsubishi Financial Group and Resona Holdings. On January 1, 2006, Tokyo-Mitsubishi and UFJ merged to form the Bank of Tokyu-Mitsubishi UFJ, the World's largest bank, with a combined asset of approximately $1.7 trillion, left the Japanese banking industry with only three gigantic banks. The Bank of Tokyo-Mitsubishi UFJ has nearly 80,000 employees and 1000 branches around the world. Additional chronology of Japanese bank mergers and acquisitions is summarized.

Several articles applied Data Envelopment Analysis (DEA) framework to measure and report efficiency comparison in Japanese Banking before and after merging. Even though bank consolidation has been viewed as a key means of improving efficiency, an average efficiency score for a banking industry did not improve much from 1998 to 1999. Harada (2005) found that Tokai Bank's efficiency score declined from 1 to 0.354 after merging with UFJ in 2001. This is due to the fact that UFJ had a very high level of bad debts, nearly 10% of the loans on its book. Therefore, a consolidation of an efficient bank with an inefficient bank does not create an efficient bank. Moreover, a merger of both inefficient banks would not lead to a more efficient bank either. An example of this result is a consolidation of Daiwa and Asahi.

Indeed, bigger does not always mean better in terms of efficiency. Nonetheless, mergers still take place as part of an effort to increase comparative advantage in banking system. Thus, incentives for bank consolidation in Japan might not be solely for efficiency improvement, but more toward combining unhealthy bank with the ones whose financial statements are in a better shape. In other words, Japanese banks decided to merge to seek for a more diversified loan portfolio, which could lower credit risk of their combined loan portfolio. The estimated bad loan is larger than $500 billion as a result of the collapse of Japan's real estate market in the early 1990s and a...

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