Banking reform in Japan continues to disappoint. The general perception is that both authorities and banks are mostly taking stopgap measures, such as the Bank of Japan’s plan to buy bank shares. Another notable example of expediency is the de facto reversal of the government decision to abolish full deposit protection beginning next April. Plans in the works call for indefinite protection of interest-free business accounts for settlement purposes.

The Financial System Council, an advisory body to the prime minister, has recommended a permanent full refund guarantee for business checking accounts. The panel has also proposed creating zero-interest savings accounts that would also enjoy full protection. The panel says settlement accounts should be fully protected against bank runs in order to avoid disruptions in business transactions.

The original plan was to lift the unlimited deposit guarantee for most types of bank accounts in April this year. As it turned out, the 10 million yen cap was revived only for fixed-term deposits, while demand deposits were granted a grace period of another year through April 2003. Now the moratorium is expected to be extended further to September next year, on the grounds that extra time is required to complete preparations for the proposed changes.

The panel recommendation is regarded as an exception to the rule. Still, it is an exception that could do more harm than good. With a chunk of deposits fully insured on a permanent basis, banks could be tempted to slow their efforts to tighten discipline and write off bad debts. Moreover, exempting selected types of accounts from the refund limit could distort the flow of deposit money, particularly in a period of near-zero interest rates, and retard the hoped-for economic recovery.

It all started with Prime Minister Junichiro Koizumi’s seemingly contradictory order to “study ways to protect settlement accounts while lifting the moratorium as scheduled.” The directive lacks clarity and consistency. It marks yet another setback to his structural reform initiative. Increasingly, Koizumi is seen as a master of compromise, rather than as a reformer of substance.

With stock prices in decline and the economy in the doldrums, the prime minister is coming under intense pressure from the ruling coalition and the business community. Politicians and business leaders argue that the full deposit guarantee now in place should be continued in its present form. In terms of consistency, however, it would make sense to reinstate the whole regime of full protection, including demand deposits.

What if such a U-turn was made? Most likely it would be taken internationally as a sign of Japan’s unwillingness or inability to impose the necessary discipline on its banks. That would further weaken confidence in the nation’s already embattled banking system. Most industrialized nations, it should be noted, place caps on bank deposits.

The official explanation for protecting settlement accounts is that transactions in Japan are settled mostly through account transfers, unlike in the United States where checking accounts are widely used. The real reason, however, seems to be that the government wants to keep the current protection virtually intact for the sake of banking stability. In fact, massive deposit shifts from small to big banks — the “flight to safety” that has accelerated since April — have been cited as a major reason to continue the freeze.

However, exempting settlement accounts from the refund limit is likely to raise more questions than it answers. Such an exception, particularly if it is made permanent, will reduce the significance of the deposit insurance system. Unlimited protection, even if it involves only certain types of deposits, will likely undermine discipline in bank management.

Checking and savings accounts make up, respectively, about 15 percent and 19 percent of total deposits, according to the Financial Services Agency. If the government plan goes through, such deposits will probably increase because they are safer than deposits that enjoy partial protection. With other types of deposits yielding only marginal interest rates, individual depositors will likely park more money in zero-interest savings accounts.

The question is, what will banks do with these cost-free deposits? They are not likely to increase lending, given continuing credit risks. It is more likely that they will invest in government bonds, which are considered a stable source of income in these times of rock-bottom interest rates. The problem is that banks’ bond holdings are already so huge that the bond market is glutted. The nightmare scenario is that the “bond bubble” might burst if the market gets a severe jolt.

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