The Bank for International Settlements on Monday issued a dire warning to Japan over the shaky position of its banking system, urging the government to explain to taxpayers that their money could again be needed to clean up the problem-loan situation.

The Japanese government “should be preparing the public now for possible increases in the government deficit” in preparation for injecting public funds into the banks’ capital accounts, the BIS said in its 72nd Annual Report, which presents its macroeconomic policy recommendations.

“The recent special examinations of suspected weak credits by the Financial Services Agency will prove useful if they induce the banks to stop providing credit to the uncreditworthy,” the Basel-based policy-coordination body for central banks said.

This in turn would force market-driven corporate restructuring that would tackle the underlying problem of inadequate profits, the BIS said.

But it cautioned, “This process of recognizing losses (from irrecoverable loans to distressed firms) could also reveal the undercapitalization of some Japanese banks and the need for some form of further government intervention.”

When banks book large losses — a step that would further aggravate their capital shortages by cutting or wiping out their profits — the government should recapitalize their capital accounts even at the risk of increasing fiscal deficits, it said.

“Policies to improve the efficiency and stability of the financial system would also be of great help in supporting sustainable growth,” the BIS added.

Unless the government comes to the rescue of the entire banking system with such recapitalization for individual banks, “a global upturn cannot be expected to have anything more than a palliative effect in Japan,” it cautioned.

The longer the Japanese economic contraction continues, the more likely the bad-loan problems will spread even further beyond the real estate and construction sectors by undercutting the quality of loans to firms in other sectors, it said.

“This would bring into question the ability of many banks to survive without additional capital from either the private sector or the government,” the BIS warned.

“A particular concern is that, in the current low interest rate environment, many weak borrowers are able to meet their interest payments even though they have little prospect of repaying their loans, or perhaps even of servicing them if interest rates were to return to more normal levels,” it said.

“Recognizing all such loans as impaired could lead to further large provisioning expenses, calling into question the capital adequacy of some banks.”

The BIS cited Japanese government data showing more than 32 trillion yen in nonperforming loans at major and regional banks as of September.

It added, “Many commentators view the official problem-loan figures as understating the true scale of the difficulties.”

In addition, the BIS, pointing to several indicators, noted that Japanese depositors’ confidence in the banking system has been undermined by a key government action.

As the government on April 1 scrapped its full-refund guarantee on time deposits in the event of bank failures, it has prompted many depositors to move their time deposits to more liquid demand deposit accounts because they retain the official guarantee until next March 31.

“With the lifting of the guarantee on time deposits, there has been a shift toward current account deposits, which retain the guarantee until the end of March 2003,” the BIS said.

“The largest banks, which are regarded as either safer or more likely to receive government assistance, have seen an inflow of deposits at the expense of regional and lower-tier banks,” it said.

In addition, holdings of foreign currency by the public have risen substantially over the last few years, as have retail sales of gold, with both trends accelerating recently, it said.

Bad Dai Nippon loans

UFJ Holdings Inc. said Monday its group banks may be unable to recover about 51 billion yen in loans to failed Dai Nippon Construction.

The loans comprise 49.54 billion yen extended by UFJ Bank and 1.45 billion yen by UFJ Trust Bank, the holding company said.

UFJ Holdings said the bad loans will not affect its earnings projection for the current year ending next March because it has already taken such measures as charging them to loan-loss provisions.

Dai Nippon Construction, an affiliate of Kinki Nippon Railway Co., filed for court protection from creditors Friday under the fast-track civil corporate rehabilitation law, with parent-only liabilities totaling 271.2 billion yen.

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