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Japan’s banking system can still be described as “fragile” or even “precarious” despite nearly a decade of supposed reforms and a wave of industry realignment, according to Benn Steil, New York-based senior fellow of the Council on Foreign Relations.

Speaking at the same symposium on Japan-U.S. economic relations, Steil said there is a lot more the Japanese government needs to do to clean up the financial sector.

He also questioned whether Japanese politicians really understand the meaning of reform, citing recent examples of ruling party actions that suggest government policies are not heading in the right direction.

In analyzing the health of Japanese banks, Steil said that after selling off about 25 trillion yen worth of bad loans, the banks still have more than 50 trillion yen in unreserved problem loans on their books. Some estimates say the figure could be as high as 75 trillion yen, and if so, “It’s even worse than we were five years ago — before the banks were recapitalized” with the injection of taxpayer money, he said.

“The situation may be getting worse,” Steil said, noting recent data showing increasing corporate bankruptcies and continuing declines in property prices.

The stock market slump in recent months, in particular the unwinding of cross-shareholdings both in financial and nonfinancial sectors, has also cut the value of banks’ shareholdings, leaving them with less financial strength to deal with the bad loan mess.

Steil pointed to the insufficient capital base of the banks. The total reported capital of Japanese banks — about 35 trillion yen — is “significantly overstated,” he said.

According to Steil, the real figure would stand at less than 20 trillion yen if 8.2 trillion yen in deferred tax assets and 7.5 trillion yen in government injected capital, which the banks have promised to pay back, are deducted.

If other questionable aspects of the banks’ capital, such as subordinated debt that the banks swap with insurance companies, are taken into account, “Banks probably have considerably less than 20 trillion yen in capital to cover unreserved problem loans in excess of 50 trillion yen,” he observed.

Steil also noted that Japan’s deposit insurance system is insufficient in that the premiums are too low and are not risk-based, which he said could “cause moral hazard in the banking sector.”

“Weaker banks . . . are not paying a premium that is sufficient to ensure that they don’t take excessive risks and threaten their own solvency,” he pointed out.

To make this system credible, the government must completely eliminate protection of banks’ nondeposit liabilities and limit protection of bank deposits to 10 million yen per customer, he added.

As a reform step that would not hurt but only help the banks, Steil urged Japan to launch the process of privatizing the state-run postal savings and life insurance systems, which “represent a huge competitive distortion in the market . . . and make it difficult for private institutions to compete.”

The government should start by making them pay taxes and deposit insurance premiums “to level the playing field somewhat” between public and private sector financial institutions, he said.

Steil raised questions about the supposed benefits of banking industry realignment in recent years, suggesting that some high-profile mergers “are not really efficiency-inducing.”

There does not seem to be a lot of complementarity in these mergers, and while the best benefit that could be expected are reduction of the banks’ cost base, they have pledged not to cut staff, he said.

While their plan to cut the number of staff through attrition would be “too slow” for the merger to have a desired effect, there is even a more serious problem, he noted.

“It is not that the banks have too much staff, but that they really don’t have the right staff for the competitive environment they are entering into,” Steil said. When in fact the banks should be aggressively competing for college graduates — new blood to come into their organization and facilitate a new strategy, they are not recruiting college graduates and leaving the new talent to foreign financial institutions, he warned.

In addition to these concerns, Steil suggested that government policy may not be heading in the right direction.

He cited recent recommendations by a Liberal Democratic Party panel that, in the face of stock market declines, call for revival of so-called price-keeping operations.

The proposal to use public money through complicated schemes to support share prices may be a “clever idea, but in the long run it would certainly undermine confidence in the market and lead to distortion in capital allocation because no one will trust the price signals coming from the stock market any more,” Steil warned.

“I think there’s reason to be concerned that the politicians really don’t know what they mean by reform,” Steil said.

He said that in his view of financial reform, a proper incentive structure should be in place to ensure that the banks do not take excessive risk.

“You don’t have to have government institutions directing their behavior on an ad hoc basis, (since) banks themselves will engage in the right behavior because the incentive structure is proper.

“But I think a lot of politicians currently see reform in terms of short-term, ad hoc measures that can be used to direct financial institutions to do specific things that may or may not be conducive to the long-term stability of the financial sector,” he said.

Steil suggested that there should be a debate on what is meant by reform in Japan “because reforms that had been undertaken today really have been insufficient.”

Kikuo Iwata, an economics professor at Gakushuin University who spoke at the same session, said that asset deflation, in which the market value of land held by Japanese corporations — particularly in the nonmanufacturing sector — falls substantially below book value leaving the firms with huge latent losses, was the main culprit behind the banks’ lingering bad loan woes.

Banks’ nonperforming loans increased as falling land prices over the years pushed down the value of loan collateral. Also faced with decreasing capital caused by stock market collapse, the banks cut down on lending, which reduces corporate investments. That, in turn, dampens demand for land and stocks.

To pull itself out from the doldrums of the post-bubble 1990s, Japan needs to break away from this mechanism, Iwata said.

One remedy for this asset deflation is to promote competition and corporate information disclosure, and accelerate disposal of bad loans through mechanism of survival of the fittest, he said, adding that introduction of the new corporate accounting rules requiring companies to report their assets at market value will be one good example.

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