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Prime Minister Ryutaro Hashimoto on Tuesday approved an outline for a U.S.-style “bridge bank” designed to prevent bank failures from disrupting the entire economy.

Funds from the government-backed Deposit Insurance Corp. should be used to set up such bridge banks, which would extend loans to sound borrowers of failed banks, Hashimoto decided while meeting with ruling Liberal Democratic Party and government officials.

Hashimoto issued the instruction to the LDP, whose task force on the bad loan problem aims to draft a plan by Thursday for creating the special state-controlled banks.

Hashimoto also ordered the Financial Supervisory Agency to develop a comprehensive plan to promote disposal of problem loans held by commercial banks. The FSA will show its plan to the LDP’s task force Thursday, said Okiharu Yasuoka, head of the task force.

Yasuoka joined a top-level meeting of the LDP and the government earlier in the day at the Prime Minister’s Official Residence, where Hashimoto met with Taku Yamasaki, chairman of the LDP’s policy research council, Finance Minister Hikaru Matsunaga and FSA Commissioner Masaharu Hino.

The bridge-bank scheme has become a focal point in a package of government measures to resolve the sour loans dragging down the economy.

The proposed bridge banks would function similarly to the bridge banks that the U.S. Federal Deposit Insurance Corp. began setting up in 1987 to bail out collapsing savings and loan associations, providing temporary solutions to problems until permanent ones can be arranged.

Under the Japanese plan, the government would create a bridge bank out of each commercial bank that fails until prospective purchasers have sufficient time to assess the quality of the bank’s loan portfolio and make a reasonable offer.

The bridge bank scheme would be used to prevent a bank failure from cutting off vital flows of credit — the life’s blood of the economy — to corporate and individual borrowers.

At the meeting, Hashimoto said a system must be established to take over the operations of banks immediately after they fail, and the system should include the functions of U.S.-style bridge banks. The Justice Ministry should be consulted to clear legal hurdles, he added.

Such a receiver bank would temporarily place a failed bank under state control and continue lending to sound borrowers.

Hashimoto went on to say that another kind of state-funded bank also should be created to prepare for the worse case scenario, in which no commercial bank dares to receive the failed bank. DIC should be used to set up this kind of bridge bank, he said.

Hashimoto did not elaborate on these instructions, according to the participants. It was not immediately clear how DIC could be used to protect corporate borrowers, rather than depositors, of failed banks.

DIC currently has a 30 trillion yen package of public funds that was adopted by the government to strengthen banks’ capital bases and protect depositors from bank failures. Hashimoto gave no specific instructions on funding for new bridge banks.

Concerning the FSA’s bad-loan disposal plan, Hashimoto stressed the need to expand disclosures by banks and reinforce checking by public accountants.

The prime minister also emphasized that financial institutions must bravely cope with realignment in the sector and their own restructuring.

The LDP and the government will decide today on the basic draft of a plan, Yamasaki told reporters. The draft is expected to be approved by the LDP task force Thursday and by its joint panel with the government by Friday.

Yet to be determined is how long a bridge bank would be allowed to operate should no purchaser be found, and how the bad and problem loans will be disposed of.

In the U.S., the FDIC was allowed under a 1987 law to operate bridge banks for up to two years, with the option of three one-year extensions for a total of five years.

After details are worked out, the government will submit a set of bills for the measures, including an amendment to the Deposit Insurance Law, to an extraordinary session of the Diet expected to convene in late July, they said.

The bills are expected to clear the Diet and be placed on statute books in September, they said.

Hashimoto emphasized the importance of preventing the severing of credit flows to what he and other proponents of the plan call “healthy borrowers” of now-failed banks that would be replaced by the bridge banks.

The bridge banks would be allowed to draw on the government-managed pool of 30 trillion yen in public funds whenever extending fresh loans to borrowers who had been counting on such credit, or for covering losses which may accrue from outstanding or fresh loans.

The 30 trillion yen was originally set aside earlier this year under a new law to help refund depositors of failed banks and revitalize banks whose capital bases have been depleted due to massive writeoffs of bad loans.

But the new legislation would now divert part of the money to finance bridge bank operations.

The LDP earlier decided to insert into the proposed legislation a clause that would empower the FSA or another regulatory agency to dismiss the management of a failed bank, and order that the failed bank be converted into a bridge bank without the consent of shareholders.

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