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Monday, May 26, 2003


Floating ABCPs on open market could repair interest rate gap

On May 17, the finance ministers of the world's major powers gathered in Deauville, France as part of efforts to set the stage for the annual Group of Eight summit in Evian. A statement adopted at the meeting urged Japan to pursue structural reforms in its financial and corporate sectors and overcome its deflationary woes.

Just a day before the meeting, however, Resona Holdings Inc., a group that has Resona Bank and other firms under its umbrella, decided to ask the Financial Services Agency for an injection of public funds. Despite efforts to beef up its capital, the Resona group reported it had developed a capital shortfall that was pulling its capital-to-asset ratio below the 4 percent minimum for maintaining domestic operations, making it difficult to do business without government support.

The next day, the government decided to inject about 2 trillion yen in public funds to Resona, believing the group's troubles, if left unattended, could explode into a financial crisis. Upon the government's request, the Bank of Japan also promptly agreed to chip in with the necessary funds. It will be the third time taxpayer money has been pumped into the banking system, and the first since a set of new legal provisions was adopted to provide a safety net for financial crises. We should closely watch how the management responsibility of Resona's executives and its shareholders will be scrutinized during the bailout process, and whether the scheme will lead to a revival in the financial sector.

The critical blow that pushed down Resona's capital-to-asset ratio was delivered by the auditors, who finally refused to recognize deferred tax assets as capital. However, the fundamental problem lies in the banking sector's weak profit-earning base, and that is what needs to be corrected. Otherwise, a capitalization boost provided by an injection of public funds will only reduce profit per share, thereby pushing down the price of the bank's stock further. So what should be done?

There are two types of monetary policy tools -- liquidity policy and interest rate policy. The BOJ is currently increasing the amount of liquidity in the market at a double-digit pace each month, but bank lending is continuing to shrink by around 4 percent each month. As BOJ Gov. Toshihiko Fukui puts it, funds are not being properly channeled through all segments of the economic system.

The biggest reason is that the interest rate mechanism is not functioning. There are two divergent trends in interest rates. While rates on bank loans are extremely low, those being charged on loans from other institutions are extremely high. If we look at banks' lending rates, the short-term prime rate stands at 1.375 percent and the long-term prime rate at 1.4 percent, with the average lending rate at Japanese banks at 1.837 percent. Given economic conditions in which the value of loan collateral tends to decline, such low rates do not seem to cover the risk of lending. As a result, banks have have become more selective about borrowers, reluctant to extend fresh loans, and adamant about not rolling over earlier ones. Meanwhile, the reorganization and streamlining of the banking sector is progressing slowly, and excessive competition has lowered interest rates and reduced profitability, further prolonging the industry's bad loan woes.

On the other hand, borrowers who have been rejected by banks are turning to other types of lenders, notably those who charge exorbitant rates. For example, rates charged by nonbank consumer loan firms range from 11 percent to the legal maximum of 29.2 percent. What this means is that there are no financial institutions in Japan that are lending money in the middle range of rates between 3 percent and 10 percent.

The BOJ is reportedly considering letting small and medium-size firms issue asset-backed commercial paper using their IOUs as collateral, and purchasing some of the ABCPs that carry lower risk. But I doubt if the measure will help resolve the problem. Low-risk ABCPs will find abundant demand in the market, and the BOJ's attempt to buy them will only squeeze out private-sector participants.

So I would propose that all ABCPs be put on the market. The market will help determine the appropriate level of interest rates for each product, depending on its risk. This will attract a variety of investors, close the above-mentioned gap, and expand options in the fundraising mechanism. By building a system to ensure risk-based continuity in interest rates and thereby restore interest rate functions, liquidity will filter down to the end users in the financial system, and subsequently restore profitability to financial institutions.

Teruhiko Mano is an adviser to Tokyo Research International Ltd.

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