Non-performing loans began to plague financial institutions in the post-bubble economy and have become a huge liability, with the total burden for banks estimated to be anything from US$350 billion to US$600 billion. Since Japanese banks make money from debt financing as opposed to equity financing, bad loans deprive banks of ready capital due and keep them in a constant balancing act. Indeed, the predicted tightening of capital adequacy ratios by Heizo Takenaka, the new Minister of Financial Services, left banks scrambling to raise funds before the end of the 2002 fiscal year.

However, higher levels of capital will not be enough to resolve this festering problem, which threatens to implode on a spectacular scale if the banks run out of capital and collapse. The strain placed by bad loans on Japanese financial institutions is so severe that a real recovery will require significant pain in the short term for gain in the long term. Both the government and the financial industry in Japan must renounce the lax or timid moves taken in the past and adopt a hard-headed approach, identifying and calling in more non-performing loans even if it means admitting that the problem is far larger than previously reported. A realistic assessment will also mean that Japanese banks and insurers must brace themselves for restructuring and corporate failures. Yet while politicians and businessmen have constantly carped of reform over the past decade, there was no significant change. Now is the time to take action so Japan can ride the next wave of global economic growth with ready capital and stable banks.

Japan’s bad loans are an unwanted inheritance from the financial bubble of the 1980’s. After the collapse in the early 1990s, businesses that had previously borrowed money were no longer able to pay back their loans. In most economies, creditor banks would have demanded payment and non-performing borrowers would have been declared insolvent, forcing them to close. In Japan, the banks shouldered their debts despite the probability that they would never be repaid. Social pressures discouraged causing bankruptcies and unemployment. For example, until the severe recession in the 1990s, Japanese corporate culture was famous for ensuring employment in the same firm from university graduation to retirement. The extent to which financial institutions neglected bad loans was exposed in November 1997, when several major securities corporations, most famously Yamaichi Securities, suffered collapses due to their inability to raise short-term funds for operation. The failures came as an immense shock, especially since they seemed to express the end of traditional Japanese economic and business values. While banks ignored non-performing loans to prevent firm failure and unemployment, the collapse of the old-line Yamaichi, employer of over 7,500 employees and victim of US$25 billion in bad loans, showed that a system of denial and deception would no longer work.

The situation worsened in 1998, when all of Asia entered a financial crisis. However, the Japanese government was reluctant to take drastic measures to set banks straight. Instead of allowing more troubled banks and brokerages to fail, the Financial Reconstruction Commission sought to prop them up, most notably in the case of the Long Term Credit Bank of Japan (LTCB), which had a capital deficit of nearly US$32.7 billion. In line with then-Prime Minister Keizo Obuchi’s vows, greatly criticized by the opposition Democratic Company, the government-run Deposit Insurance Corporation helped clear LTCB’s capital deficit, absorbing US$37 billion in bad loans. After seizing control of LTCB, the government arranged for the bank to be reconstructed as a foreign consortium led by an US investment company and as a domestic long-term credit institution, Shinsei Bank, in 2000. The government went further with its aid, purchasing US$2.2 billion worth of Shinsei’s preferred stock.

As its name “Rebirth” suggests, Shinsei Bank went on to defy its troubled origins. The bank declared US$730 million in earnings for the 2001 fiscal year, earned US$501 million in 2002, and projected a US$512 million profit for 2003. In contrast, other banks are suffering from an estimated US$38.1 billion in equity losses, some realized and some unrealized. Heavily invested in the stock market, banks were particularly hard-hit in the 2002 fiscal year that just ended, because the benchmark Nikkei 225 stock market average plummeted by 27.7 percent over the year to ¥7,972.71 on March 31, 2003, the lowest end value for the Nikkei since 1982. Shinsei has been so successful because it aggressively demands payment from deadbeat borrowers, raising capital and expanding retail ventures with the new cash. From mid-2001 until the end of March 2003, Shinsei had taken in more than US$8 billion in deposits since mid-2001. Their capital-adequacy ratio was an enviable 19 percent in comparison to the average 10 percent ratio of Japan’s huge banking groups, such as the behemoth Mizuho Financial Group with US$1.28 trillion in assets.

Banks like Mizuho must follow in the lead of Shinsei Bank and raise their capital. Although their capital adequacy ratios are still above the international requirement of 8 percent, the big banks’ US$141 billion tier one capital is cushioned by US$49.8 billion in public funds lent by the government in 1998 and US$69.7 billion of deferred taxes. The government has recently made a greater effort to force banks towards action; when Prime Minister Junichiro Koizumi appointed Heizo Takenaka as the new head of the Financial Services Agency (FSA) on September 30, 2002, he tried to reduce the amount of deferred taxes that banks can count as capital and catalyzed a capital scramble. However, much of the banks’ efforts showed that they are still in trouble; Mizuho issued costlier preferred shares to foreign companies and only the Mitsubishi Tokyo Financial Group felt financially sound enough to shore up its capital base through a public share offering.

Yet ultimately the raising of capital through equity is a short-term solution to a long-term problem; the bad loans must be eliminated for banks to achieve long-run stability. The loans can be bought with public funds and sold off cheaply or erased by the government. More radically, they can be called in, causing the bankruptcy of borrowers in construction and retailing as well as huge losses and failures at banks. Takenaka seems willing to take the drastic approach. He aims to reduce the misclassification of non-performing loans by creating a database of over 150 major non-performing borrowers. Takenaka has also formed a new 19-man specialist team to prevent banks from lending to firms with weak financial bases.