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Monday, June 18, 2007

JAPANESE PERSPECTIVES

What the Basel regulations mean for the Japanese banking industry and monetary policy


Anew set of rules governing capital adequacy of banks debuted this year, and Japanese banks, many of whom close their books in March, became the world's first to announce their earnings results under the new standards.

Thanks to Japan's continuing economic expansion and the recovery in the stock market, the capital-to-asset ratios of major Japanese banks are now in a range between 11 percent and 13 percent, under "Basel II: A revised framework — Comprehensive version."

Its predecessor, Basel I, was endorsed in 1988 and required banks with international operations to keep capital-to-asset ratios higher than 8 percent. It was designed to establish an internationally unified standard for assessing their financial health in the wake of a string of bank failures caused by currency exchange losses and sovereign crises in some Latin American countries.

However, the uniform nature of the regulations was also its main weakness.

For example, Basel I required a bank to count all of its corporate lendings as assets — irrespective of the financial health of each borrower.

Discussions on Basel II began in 1998 to correct the shortcomings of Basel I. After a series of changes to the draft, the world's financial regulators reached a final agreement in 2004 to implement the new rules this year. The new rules allow each individual bank to include its own methods for evaluating credit risk.

Looking back on the process from the agreement on Basel I in 1988 to the implementation of Basel II today, it does not seem an overstatement to say that Japan's economy and its banking system were left at the mercy of these capital adequacy regulations.

In the first stage of this process, the regulations — for all publicly stated intentions — had the effect of reining in Japanese banks. Reform of the Japanese banking system — which developed along with the nation's highly intensive postwar development spurt — was lagging despite the rapid internationalization of its economy.

There was concern that the Japanese banks' strategy of expanding business at low profit margins would disrupt the international financial order. During a Group of 10 meeting in 1984, then Federal Reserve Chairman Paul Volcker called for tightening unified international regulations on the industry. In addition to its original purpose, which was to maintain the health of the international banking system, Basel I was responsible for dealing with the rules of competition among banks.

A series of high-profile purchases of iconic U.S. assets powered by skyrocketing real estate and share prices of Japan's asset-inflated bubble economy — including the 200 billion yen deal for Rockefeller Center in New York — only magnified negative views of the Japanese financial industry.

At that time, some U.S. media accused Japan of taking the soul of the United States with its money. It was also true, however, that Japanese banks were undercapitalized by global standards. Japan's financial authorities had to cope with the new rules by counting the banks' unrealized gains on stockholdings — up to a certain level — as supplementary capital.

In the second stage of the process, however, this decision backfired after the bubble imploded. The collapse of Japan's stock and real estate prices, in addition to the explosion in nonperforming loans, reduced the banks' capital and therefore made them extremely reluctant to lend and eager to call in their loans.

What made matters worse was a rule under Basel I that said government bond holdings could not be counted as assets because the risk ratio of bonds issued by industrialized countries was zero. In order to shrink their assets and thereby prevent the decline of their capital adequacy ratios, Japanese banks reduced lending to individual and corporate customers — which had to be counted 100 percent as assets — and invested their money instead in government bonds.

It was at this stage that the realignment of the Japanese banking industry began to accelerate. But while the nation has already witnessed the reorganization of its major banks, a full-scale realignment of local banks — facilitated by a sense of crisis over the privatization of the state-run post office and its financial services — is just beginning.

Meanwhile, the combined net profits of 89 listed domestic banks for fiscal 2006 have declined 15.2 percent compared with the previous year.

The third stage of the process has yet to begin. While Japanese banks have closed their books for fiscal 2006 under the Basel II rules, none have adopted the newly authorized internal credit rating method.

Banks taking advantage of the new method need to provide past records to justify their own international ratings, but the major Japanese banks — having gone through a series of mergers — do not yet have records to prove their credit ratings are valid.

The changes in the Basel regulations coincided with the formation — and collapse — of Japan's asset-inflated bubble economy and were partly responsible for delaying its recovery.

The Bank of Japan's ultra-easy monetary policy — one of the measures taken to pull the nation out of its decade-long post-bubble funk — has contributed to today's global glut in liquidity and is now a target of international criticism, along with the current account deficit of the United States and the excess domestic liquidity China has produced by "intervening" in the currency market.

The BOJ should not forget the lessons learned from the bubble and should pursue monetary policy from an international perspective.

Teruhiko Mano is a professor at Seigakuin University Graduate School.


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