The Bank of Japan announcement that it would purchase part of the stakes that banks hold in listed companies has raised question marks among investors.
The stock market greeted the good news with a spectacular rise. This was all the more impressive as stock markets elsewhere ended the day with another miserable performance. On the other hand, both the yen and government bonds dropped sharply after the announcement.
The BOJ initiative closely follows a decision by the Development Bank of Japan, a public institution, to purchase credit-linked securities issued by large commercial banks that need to trim their balance sheets. Hence, in just a few days, the authorities have arranged all conceivable means of propping up the banking system.
The massive 150 trillion yen in bad debts sitting on Japanese banks’ books is indicative of their critically poor health. The extent of the problem should come as no surprise, however. As is well known, in Japan the banking system is in charge of financing the economy. In contrast, in the United States financial markets assume this responsibility.
This means that in Japan, banks support the risk associated with the business activities of corporate firms. In the U.S., this risk is transferred to end-investors, meaning households bear the risk. Enron employees know all too well about risk-taking after losing both their jobs and their lifetime savings.
Even though U.S. banks may at some stage contribute to financing the corporate sector, they reduce their exposure by taking such assets off their balance sheets by way of the securitization process. Loans are repackaged and the corresponding asset-backed securities are sold to investors, who then carry the business risk of the banks’ borrowers. As such, banks end up carrying little of the risk generated by economic activities. Instead, households ultimately assume them. In fact, bank deposits represent only 12 percent of household financial assets.
Although securitization has been available for a while in Japan, its economic contribution is comparatively trivial. Except for speculative foreign funds, such as hedge funds, there aren’t many investors willing to take the risk. This is one reason why the Resolution and Collection Corporation, formed to solve the bad-debt problem, is so slow to complete its mission.
The obvious way to reduce the heavy burden on the banking system would be to promote the growth of the stock and corporate-bond markets. Europe has been fairly successful in attracting cautious households to the stock market and developing a vibrant mutual-fund industry.
Corporate securities in Japan invariably end up on the balance sheets of banks. For instance, corporate bonds are mainly purchased by banks and insurance companies — a sign that credit risk cannot be transferred outside the banking system.
It is also no secret that banks hold massive stock portfolios. These long-term stakes were built up initially as part of a strategy that did well in fostering Japan’s postwar economic recovery. Thanks to these equity stakes, banks were able to share the economic success of their corporate customers while supplying them with cheap credit lines. With the recent plunge of the stock markets, these equity stakes now prove to be double-edged.
But how can banks reduce them? For that purpose, it would be necessary to involve outside investors. Households, obviously, don’t have much appetite for risk. They only hold 20 percent of the stock-market total capitalization compared with about 40 percent for banks (banks in the U.S. are prohibited from holding corporate equity).
Providing loans is considered risky enough. As a result, 85 percent of Japanese household savings is held in bank deposits or life-insurance products with fixed annuities. Only 7 percent is invested in shares and equities. As for the American-style 401(k) defined contribution pension funds that have been recently introduced, they simply aren’t large enough to take over the job.
Japanese banks are thus trapped with all possible economic risks piling up on their balance sheets. Considering that it is not easy to transfer these risks from banks to households, the only readily available solution is public intervention. In extreme cases, nationalization is necessary, as with the defunct Long-Term Credit Bank of Japan. But what, then, is the basis for public intervention if not to protect the interests of Japanese households?
In a time of both misinformation and too much information, quality journalism is more crucial than ever.
By subscribing, you can help us get the story right.