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For all practical purposes, big banks in Japan have turned the corner in their efforts to clean up their bad loans. For small and medium-size banks, though, no light is yet visible at the end of the tunnel. With caps on deposit insurance due to be fully reinstated next April, smaller lenders have no choice but to speed up bad-debt disposal and put their financial house in order.

The government is now ready to help these smaller banks, including regional banks and credit unions. Assistance is available under a new law that calls for preventive bailouts of ailing banks to support restructuring measures such as mergers and reorganizations. The law, which took effect last month, is intended to serve as a safety net for regional and community banks. Prevention is better than cure, as the saying goes.

Local lenders and businesses, especially small ones, are bound tightly not only by geography but also by a shared sense of destiny. Community-based businesses are trying hard to survive amid persistent deflation, but their chances of survival will diminish, or even disappear, if troubled lenders are forced to cut off credit supplies.

In fact, that is essentially what happened with the collapse last autumn of Ashikaga Bank in Tochigi Prefecture. The regional bank, now under government control, is in the process of reconstruction. The lesson from Ashikaga is that local bank failures must be prevented to give regional economies and industries the best chance for a solid revival.

Economic recovery in local areas is lagging far behind that in urban centers, making it urgent to improve the health of local banks. Local banks, like big banks, went on a lending spree during the stock and real estate bubble of the 1980s. The collapse of the bubble at the start of the 1990s left them with mountains of bad debt.

Now, however, all major banks — except UFJ Holdings Inc. — are expected to achieve, by the end of next March, the government-imposed target of halving their ratio of bad loans to total lending. By contrast, local banks are still saddled with disproportionately large amounts of bad loans. As of March 31, regional banks and smaller second-tier regional banks held a total of 12.8 trillion yen in nonperforming loans, less than a 2 percent drop from a year earlier, according to the Financial Services Agency. The corresponding figure for major banks, including city and trust banks, was 13.8 trillion yen in nonperforming loans, down about 7 percent.

The lag in bad-debt disposal by local banks has much to do with the characteristics of regional lending, particularly their close ties with small businesses that may be financially weak, such as family-run operations and “mom-and-pop” shops. That is one reason why the government did not impose numerical debt-reduction targets for smaller banks. Local lenders’ limited assets and earnings are another reason for delays in debt cleanup. Obviously, the bank assistance law is designed to bolster these smaller lenders. The most notable feature is that public capital may be supplied “preemptively” to weak lenders before they become insolvent, even if they meet capital requirements.

The basic idea is to bail out a troubled bank before it goes bankrupt. That goal became clear following the failure of the now-defunct Long-Term Credit Bank of Japan and Nippon Credit Bank. The government injected large amounts of public money into both banks only after they became insolvent. But the bailouts increased doubts about Japan’s financial system, thus creating more, not less, unrest among investors and depositors. The new legislation seems to reflect the determination of financial regulatory authorities to prevent a credit crisis from occurring in the regional banking sector.

Indeed, there is good reason to expect that the law will help improve the balance sheets of local banks. The fact remains that the quality of their capital and assets is poor compared with that of large banks. The question is whether lenders will be willing to receive public assistance on a preemptive basis; for a bailout does bear the stigma of failure.

Beyond that, a public bailout risks undermining discipline in private bank management. The risk is that banks may put off the hard decisions that must be made, such as making drastic changes to their operations, if they get an emergency cash infusion. It is the responsibility of both the government and lenders involved to ensure that this does not happen.

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