Some homework – in light of the latest bailout last night.
Lessons from the Japanese banking crisis.
Three papers, below, to read and annotate. But just before, a quick recap on the protracted – though steady – global writedown process (red line) of the current banking crisis so far:
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(Beginner’s level) The Japanese Banking Crisis in the 1990′s (Ueda – BIS)
Without doubt the regulators underestimated the negative effects on the economy of the bad loans problem in the 1990s. As a result, their approach to the problem has been one of forbearance.
Since the early 1990s, both banks and regulators have been trying to achieve at least two ends, reducing bad loans and meeting the Basel capital standards, with sometimes only few instruments at hand.
Large Japanese banks had capital ratios of barely above 8% at the start of the 1990s, with about half of the 8% accounted for by unrealised capital gains on their equity positions. Since then, banks have been writing off bad loans by basically using operating profits and realising latent gains on equity positions. This meant that every time equity prices plunged, banks faced the risk of not being able to meet the Basel standards or having to slow down the pace of bad loan write-offs… What has filled the gap is a sharp increase in other components of Tier II capital, mostly subordinate bonds and loans.
More capital = more writedowns.
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(Intermediate) The Japanese Banking Crisis of the 1990′s: Sources and Lessons (Kanaya, Woo – IMF)
After the bubble burst, banks nevertheless still tried to raise capital in the market, prompted by the need to increase their write-offs and provision for rising non-performing loans… banks raised their capital by issuing debt instruments that convert into equity after several years. This form of new equity issues with delayed conversion apparently was designed to “placate Japanese regulators who appeared to believe that ordinary equity issues would at least depress a bank’s stock price if not the level of Japanese stock prices in general”. Ammer, Gibson and Levy (1996) and Ammer and Gibson show that these banks actually had to pay a substantial premium to raise capital in this way.
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Consequently, all major banks applied for public capital injection. Because weak banks did not want to draw attention to themselves by applying for more capital injection than the stronger ones, most of the banks applied for the same amount.
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To help banks further strengthen their capital positions, if only merely for the books, the authorities relaxed accounting rules.
And some extra homework for Vikram on government asset-price guarantees (last night’s bailout let you reduce Citi’s risky asset weighting to 20 per cent under Basel II capital directives):
The banks exploited the [credit] guarantee schemes, because, for the purpose of calculating the BIS capital ratio, they were allowed to attach a zero risk weight to government guarantee loans.
By 1998, the government schemes had been growing so rapidly that they largely exhausted their funding. The government offered additional funding in late 1998 and a new round of funds was approved in the summer of 1999. In September 1999 the government announced yet another scheme.
Transparent accounting standards (such as pertaining to loan classification, accrual of interest and marking-to-market of assets) are an important tool in effective supervision. Accounting standards should be used to promote substance over form and to discourage manipulation.
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(Advanced) The financial crisis in Japan during the 1990s: how the Bank of Japan responded and the lessons learnt (Hiroshi Nakaso – BIS)
One of the peculiar aspects of Japan’s banking crisis is the length of time that has been required to bring the problem under control. The magnitude of the bubble and thus the resulting size of nonperforming loans were so enormous that they were far beyond anyone’s expectation at the time. It was not until March 1998, almost eight years after the bubble burst, that serious measures including the use of public funds began to be taken in an attempt to prevent a further deterioration in confidence in the financial system.
In retrospect, it seems difficult to deny that obscured capital ratios of Japanese banks, their general reluctance to admit the need for recapitalisation, and the jusen problem contributed to delaying the timing of the capital injection.
[For jusen, perhaps, read Frannie]
In the winter and spring of 1999, the FSA concluded that the self-assessment of asset quality undertaken by the banks in March 1998 was based on too optimistic assumptions and that the major and regional banks had significantly understated their non-performing loans.
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