Japanese banks have been plagued by trouble for decades. So when good news came out last week that they had finally achieved a key loan performance target set three years ago, there was call for celebration.

The banks’ biggest thorn in their side has been bad loans. While many American banks make loans based on formulaic approaches (i.e., you have bad credit = you pay higher interest rates), the Japanese were placing heavy weight on certain considerations that prevented them from forcing recipients to either pay up or go insolvent. A look at these considerations is helpful, because they don’t show up in the models of their foreign counterparts and contribute significantly to the Japanese banking system crisis.

The first consideration is cultural. When individuals or corporations stopped making payments, Japanese banks felt social pressure to keep them afloat to avoid creating embarrassment through bankruptcy or unemployment. When society tells citizens that it’s prestigious to work for the same company from the day you step off campus until the day you start shopping for false teeth, office closures, sweeping management changes and liquidations just don’t fit. So instead of following mathematical formulas and calling in loans when borrowers misbehaved, banks in Japan hesitated. Bad loans stayed lent out, and the banks suffered.

The second consideration is fancy tax laws. Banks all over the world have what is called “capital requirements”, which means that they must keep a certain percentage of deposits in cold hard cash (or something almost as liquid) as a cushion to make sure that they don’t stretch themselves too thin when they lend out money. The goal of this is to prevent bank runs. There are a bunch of international institutions that have come up with complex formulas to determine the optimal percentage for this requirement - a magical 8%. Although the Japanese banks were meeting this requirement, part of this cushion for many banks was comprised of “deferred tax assets”. These “assets” were in fact an accounting concept whereby banks meeting certain loan loss reserve thresholds could eventually collect tax refunds. They figured, if they know the tax money is coming, they can count it as part of their "pool". The problem is that refunds only come when you pay tax, and you pay tax only when you earn income. So when your bank makes losses year after year, this “asset” becomes a fiction and does not really support what the cushion was supposed to do in the first place.

What does this have to do with bad loans you ask? Well, it is easier to subsidize bad loans with good loans if you can use more of your capital. Having to use less of your capital to fulfill the 8% requirement gives you more leeway to lend, lend, lend.

The third consideration is government bailout. Similar to the 1998 Asian economic crisis, loans were being made in Japan under the assumption that if enough loan recipients did not pay, the Japanese government would bail out the bank to save it. A jump off a cliff seems less risky when there’s a safety net.

The good news that came last week was exciting. Bad loans had declined from over 8 percent in 2002 to under 3 percent this spring. Perhaps this means that culture is changing and the banks are tweaking their models to let the market forces determine when to say one should pay up or close shop.

Or maybe those hardworking bankers just needed an excuse for a party.

Posted by Michelle Smith on June 15, 2005 10:29 AM