What's next for Japanese banks?

• Author: Root, Gregory A.
• Position: Includes related article - Capital Markets

As the Nikkei index vacillates and bank assets deteriorate, Japan needs to take a close look at the fundamentals of its financial system.

The economic success that Japan enjoyed following World War II depended on its ability to produce high-quality products at low cost to the consumer. Japan operated very much on a high-volume, low-margin basis, with a long-term approach to business development. This approach was possible because of a strong work ethic and a very close relationship among corporate entities, the government, and the banking system. As we know only too well, the system worked well--that is, until the Japanese economic bubble started to break in 1990.

The bubble began to form in 1986, when Japanese government officials introduced an easy money policy in an attempt to strengthen the yen and bring down soaring trade surpluses. The low-cost capital unleashed a flood of lending and speculative activity on the stock market, which soared past 39,000 yen on the Nikkei index at its peak in December 1989.

As the market went up, banks became heavy lenders, investing primarily in real estate not only in Japan but around the world. Also investing heavily in real estate and other "bubble" sectors (the stock market and art, among the most notable) were the non-bank financial companies, many of them set up by the banks and by traditionally conservative manufacturing companies. Real estate prices went through the roof.

In the spring of 1987, Japan's regulatory authorities moved to clamp down on speculation and illegal financial activities. The Bank of Japan drained liquidity from the money markets and pushed up interest rates, and the Ministry Of Finance (MOF) indicated that it would tighten bank accounting and regulatory standards. But following Black Monday in the U.S. in October 1987, the world feared a severe economic depression. Japan's central bank eased money once again, and the MOF put its reforms on hold.

Then, in 1989, in response to increasing abuses in the system and highly inflated real estate prices, the Bank of Japan again tightened monetary policy, leading ultimately to a severe correction in stock prices early in 1990. This, combined with the outbreak of hostilities in the Middle East, caused stock prices to fall nearly 50 percent from December 1989 to September 1990. Since then, the Nikkei dropped another 20 percent, although, as this article goes to press within days of the Japanese government's announcement of its new package to stimulate the economy, the market is more uoyant.

At about the same time that the central bank tightened money in 1989, the MOF imposed limitations on new financing for real estate. The result of all of this was downward pressure on real estate prices--and a serious cash flow squeeze for many of the most aggressive bubble companies. For the first time in almost 20 years, real estate prices in Japan dropped. The government reported that last year, land prices were down about 5.5 percent. In reality, however, the drop was much greater. It's difficult to determine where equilibrium exists in the overall market because there are so few transactions. Further obscuring the picture is the fact that prices vary dramatically from sector to sector. In Osaka, for example, the depreciation of condominium values over the last 18 months was estimated to be 40 to 50 percent.

Yet, even through 1991, despite lower overall lending growth, banks allocated a...