International Finance

1. International Finance The Japanese Financial System Week Six, Class One Professor Diamond

2. International Finance • Outline of Key Issues: • Brief post-World War I history • 1992-2005: The Lost “Decade” - the NPL’s • Regulatory Structure: breakup of MOF and creation of Financial Services Agency (FSA) • Changes in bank ownership from bailouts, mergers and sales to foreign investors • Deposit insurance reforms: removal of moral hazard • The failure of Big Bang to stimulate capital market • Postal Savings Reform • Reemergence

3. International Finance • Post-World War I: creation of modern economy and financial system • Late Industrializer • Authoritarianism essential: Bonapartism • Bismarck/Stalin • 1940s centralized economic control for total war • 1946-1980s: post-war reconstruction (managed high growth) • Zaibatsu to Keiretsu • Confrontation with left and labor • 1980s: bubble economy and bank expansion • 1992-2005: lost “decade”

4. International Finance • Japan’s Postwar Model: • Dominance of banking over capital markets • Tight controls over generation and flow of investment capital • Foreign exchange controls on inflow and outflow of capital • Hierarchy of segmented financial intermediaries • Keiretsu and cross-shareholdings • Tight controls over competitive variables in financial services • entry and exit, new products, pricing, fees, rates, foreign market access, foreign exchange • Promotion and protection of financial service cartel: convoy • Reliance on “administrative guidance” • “Main Bank System”: corporate governance surrogate

5. International Finance • The “lost decade” a result of the late 80s bubble • How big a bubble? The Imperial Palace valued at more than California (yes, Virginia, California!) • Japanse buy Pebble Beach! • So, what caused the bubble?

6. International Finance • Tripartite tensions of Cold War era • Japan and Germany lost the hot war but rebuilt anew • New forms of industrial relations • Government directed and bank controlled credit to industrial companies • U.S. global dominance suffered

7. International Finance • As aging U.S. industrial plant lost ground, political pressure built up in the U.S. • Reagan wanted to lower interest rates to spur production • But if Japan did not go along too money would flow out • Plaza and Louvre Accords - Japan agrees • Cheap money in Japan triggered bubble • And all bubbles eventually burst (dotcom, telecom, 1929; housing?)

8. International Finance • The so-called “Lost Decade” - output and prices • Economy grew less than 2% annually from 1992-2004 and much less than U.S. at 3.2% • Deflation in every quarter since the third quarter of 1994 • What was the cause?

9. The Lost Decade:Losses in Asset Prices Peak Most Recent A Fall in Market Capitalization: Tokyo Stock Exchange (1st Section) Loss in Stock market Total Loss ¥623.0 Trillion ¥359.8 Trillion ¥263.2 Trillion ¥1, 263.2 Trillion (Dec. 29, 1989) (Feb. 15, 2005) A Fall in Land Prices (Approximate) Loss in Land Prices ¥2,000 Trillion ¥1,000 Trillion ¥1,000 Trillion About 250% of Nominal GDP (1991) (2004)

10. FSA’s NPL Analysis (Tn Yen) 1999/3 2000/3 2001/3 2002/3 2003/3 2004/3 2004 33.9 31.8 33.6 43.2 35.3 26.5 30.0* *7% GDP (USD264 bn) Independent Analysts 150.0Y ($1.2T) (25% GDP)

11. What is behind the phony numbers? • As in all things, politics! • And, as Tip O’Neill said, “all politics is local” • Japanese macro accounting is similar to Hollywood accounting: an art not a science • LDP and government bureaucracy move to protect the system • If the banks were bankrupt, zombie companies could not be kept afloat (no bank money): estimated that if all bad loans in 2002 had been written off, unemployment would rise by 143,000 and 72,000 would drop out of work force—loss of votes, and high cost of unemployment compensation, estimated at ¥860 billion per year ($8.6 billion)

12. Behind the NPL numbers • Cover up with foreign “technology” as in CSFB case—probably with knowledge and perhaps acquiescence of MOF—removed bad loans for cash during inspection, then returned to bank • If the banks were acknowledged to be bankrupt much more public money would have to be spent, which would be hugely unpopular for LDP (typical problem in bad bank crises) • Senior management of bankrupt banks would be fired, and perhaps prosecuted (happened later than sooner) • MOF would be blamed and held accountable (happened later than sooner with breakup)

13. Behind the NPL numbers • Tier One Banks must maintain 8% capital adequacy ratio • Ratio of “capital” to assets • In banking, loans and investments are assets • Capital is equity (c/s, pfd, retained earnings) and other ownership stakes in the bank • In theory, a cushion against losses • Japanese banks came close to crossing the line in 2003 as Nikkei fell below 8,000 (20 year low)

14. Responding to the NPL crisis • As economy slowed, interest rates approached zero • Money was free and economy still languished • Taxes cut • Bonds issued by government to raise money to bail out banks • Allowed banks to report DTA’s as tier one capital, thus maintaining fiction of capital adequacy • Suggests problem with unenforceable global standards

15. End of the NPL crisis? • NPLs 2005 $150 billion, 3% of GDP down from 4% in 2004 (FSA target set in 2002) • Early repayments by major banks: 2006 • Sumitomo-Mitsui to pay back $5.2 billion of $9.6 billion • Mitsubishi-UFJ to repay $7.1 billion • Mizuho also to repay entire borrowingNPLs increasing because of new bad loans to old bad borrowers: political pressure to give zombie companies more money • IRCJ (borrower workout agency) to dissolve in 2006

16. Post-NPL fallout • Restructuring of regulatory agencies • MOF mismanagement in 1990s leads to breakup of authority: creation of FSA and independence of BOJ • FSA: more politically responsible than MOF but continues total concentration of regulatory authority • FSA more transparent and rule-based than MOF • But does MOF control FSA through revolving door or personal ties? • Hawk or Dove viewpoint?

17. Banks restructure • New public funds: ¥ 90T (20% GDP) • Capital injections • Fund for disposal of bankrupt banks, ¥17T • Fund to purchase bad debts of banks under temporary public control, ¥18T • Government owned 90% of bank shares (preferred stock convertible into common) • Weakest banks merged into less weak banks • Takeovers

18. Delayed reform of deposit insurance • Idea of limited deposit insurance protection is more market discipline—depositors over ceilings are at risk • Unlimited time deposit guarantee removed in April 2002 • Now 75K per person per bank • Planned April 2003 removal of unlimited guarantee of demand deposit accounts and substitution of ¥10 million ceiling ($84k) was deferred until April 2005 • Reason for deferral: threat of run on banks, capital flight or vast expansion of postal savings system which is backed by complete government guarantee

19. Big Bang! • Big Bang, announced on November 11, 1996, was trumpeted by the then Hashimoto government as a sweeping reform of the financial markets, particularly the capital markets (at first just a concept) • Bank centered system not capital market centered as in U.S. and U.K. - similar to Germany • Japanese securities: <14% of financial assets • U.S. securities: >55% of financial asets • Japanese cash or on deposit: 55% • U.S. cash or deposit: 13%

20. Japan’s Big Bang (1996) • Hope that K markets could take up slack from banks • Pressure from U.S. (hawks) to open up (Goldman and Merrill wanted in) • Measures: • liberalize foreign exchange • break down structural barriers between different financial institutions • free up prices (e.g. abolish fixed brokerage commissions) • open up to foreign firms and products easy market entry to firms and issues, • lower taxes on financial transactions (lower capital gain rate, abolish transaction taxes)

21. Postal Savings: Godzilla Total deposits of Yucho (Postal Savings) were roughly equal to total deposits of four major banks. Total Deposits (End-Dec. 2004) ¥227.3 Trillion ¥225.9 Trillion Yucho (Postal Savings) Four Major Banks

22. Privatization of Postal System • Four postal businesses—over-the-counter services, postal delivery, Yucho (postal savings) and Kampo (postal life insurance) will become separate subsidiaries of a holding company, wholly owned by the government, in 2007 • Each subsidiary will be 2/3rd privatized by 2017 (state share remains 1/3rd), guarantees removed, employees lose civil servant status • Break with social contract could lead to unrest • Will this reform improve the financial system? How should it be changed?

23. Postal Savings • Reasons for privatization • Halt allocation investment in non-productive “political” assets (like wasteful construction projects) which are about ¥78T (16% GDP) • Shift use of personal savings to productive assets such as business loans or private equity business • Create even playing field with banks for attraction of deposits (postal savings has complete guarantee, and no cost of capital, taxes or deposit insurance premium obligations) • Avoid potential losses from guarantee • Eliminate source of political patronage for postal lobby of LDP

24. Privatization Problems • Will create a huge new competitor for banks on the asset side, e.g. loans • Formal removal of guarantees will be meaningless because the privatized Yucho will be too-big-to fail • A better plan would be to put declining caps on liabilities, thus forcing new deposits to go to private sector and lead to long-term phase out of postal savings system (but are deposits running off anyway?)

25. Foreign banks increased role • Very small part of banking system but high performing • Shinsei Bank (old LTCB) achieves successful IPO 2/04; controversial agreement of DIC to buy back loans that fall in value by 20% in 3 years and to guarantee all liabilities, e.g. bonds, swaps • Private equity enters picture - Ripplewood, GE Capital • Ripplewood put 1 bn into Shinsei, took out 2.3 bn! • Is foreign ownership a step in right direction? Better management and less responsive to political pressure to save “zombies” • But now proposed “Shinsei tax” on private equity investors (spurred by large profits and high Shinsei IPO price)

26. Foreign banking presence ActivityShare Year Lending 13.7 2004 Foreign Exchange Trading 71.1 2004 Japanese Public Equity 21.8 2004 Brokerage 39.9 2004 Japanese Cos. equity deals 36.9 2004 IPOs of Japanese Cos. 38.7 2004 M&A with Japanese Co. 65.6 2004

27. Big Bang, a Bust? • Capital markets are still moribund, why? • Falling equity markets are unattractive to investors • Local corporate bond markets are less attractive than international markets • Markets are viewed as rigged (Livedoor) and subject to government intervention and interference (attack on derivatives); disclosure inadequate • Perceived hostility to foreign banks: stock-for-stock acquisition rules, nit picking inspections and business suspensions • Banking system doldrums had triple effect: banks do not pursue opportunities in capital markets when worried about survival, banks continue to promote banking at expense of capital markets, underlying corporate market distorted by zombie maintenance

28. International Finance • Fallout from lost decade on corporate governance • Capital markets rely on governance to mitigate agency issues • Keiretsu emphasize “corporate constituency” over “shareholder value” • Similar to backlash in US over LBO’s in early 90s • But reform underway in late 90s

29. International Finance • Corporate governance reforms • Enhanced management flexibility as constituency standard is weakened • Mergers and asset sales easier • Stock options now possible • Increased role for directors and statutory auditor • Banks forced to divest in crisis • Banks share of TSE from 43% (1992) to 35% (2004) • Retail investors up from 25 to 35 mn (92-04) • Foreign holders up from 6% to 22% (92-04)

30. International Finance • Statutory Auditor • Similar to German Supervisory board • But weaker • Must now be 50% outsiders (SOX US 100%) • One board system now an option (2002) • 107 firms have adopted • Effectiveness uncertain yet • Takeover market? • Hostiles rare • Livedoor bid for Nippon

31. International Finance • Market for Corporate Control in Japan? • Livedoor (an ISP) v. Nippon Broadcasting • Hostile bid • 33 y.o. Takafumi Horie (a kind of hero) • Nippon owned 22.5% of Fuji TC and sought defensive merger • Lehman Bros backed Livedoor

32. International Finance • Nippon paid Livedoor substantial greenmail to go away • Poison pills emerged • But require shareholder approval (not in US!) • Horie nominated for office, and lost • Then, 1/06, Livedoor raided, Horie arrested on fraud charges • TSE falls sharply on news (what does that mean?)

33. International Finance • Regulatory framework • SROs and Government regulation • SROs: the exchanges and the Japanese Securities Dealers Association • Public regulation was under MOF • Now, Securities and Exchange Surveillance Committee is part of the new Financial Supervisor Agency formed in 1997 in wake of bank crisis, apparently a blow to MOF power • SESC considered weak - tiny budget compared to SEC (US)