Japanese banking problems: implications for lending in the United States - Industry Overview

New England Economic Review,  Jan-Feb, 1999  by Joe Peek,  Eric S. Rosengren

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A unique combination of institutional characteristics of the Japanese economy at that time produced a framework particularly suited to transmitting such a domestic financial shock to other countries through the behavior of the Japanese banking system. Changes in bank regulation in the late 1980s, including the adoption of the Basle Accord which placed greater emphasis on the role of bank capital, made Japanese banks take satisfying capital requirements more seriously, while at the same time codifying the direct impact of fluctuations in stock market values on the level of a bank's capital. Japanese banks are allowed to hold cumulatively large equity stakes in publicly held firms, and the accrued capital gains on these holdings can be included in bank capital; because of this, the dramatic decline in Japanese stock prices reduced bank capital substantially. As a consequence, Japanese banks came under strong pressure to downsize their activities in an attempt to raise capital-to-asset ratios.

However, the resulting shrinkage was concentrated overseas rather than in their domestic operations. First, the particularly close relationships that Japanese banks have with their domestic loan customers provide them with a strong incentive to insulate their long-term customers from a reduction in credit availability. Second, the large overseas presence of Japanese banking organizations provided an escape valve for the pressure on them to shrink. By concentrating the shrinkage of operations on overseas rather than domestic lending, Japanese banks mitigated the adverse effects on their domestic customers and transmitted to other countries what was originally a domestic shock.

II. Pressure on Capital Ratios and the Japanese Bank Response

A substantial body of evidence indicates that banks in the United States respond to adverse capital shocks by growing more slowly and, in many instances, shrinking (Bernanke and Lown 1991; Hall 1993; Hancock and Wilcox 1995; Peek and Rosengren 1995a, 1995b, 1995c). While investigators have found a positive relationship for Japanese banks between bank capital and either asset growth (Frankel and Morgan 1992) or bank lending (Kim and Moreno 1994) after the mid 1980s, before then the relationship was much weaker or nonexistent. This is consistent with a change in the regulatory environment in Japan in the mid and late 1980s. Essentially, Japanese banks had not been subject to explicit capital ratio requirements until the mid 1980s. (See Kim and Moreno 1994 for a more detailed discussion.) Rather, the Bank of Japan often controlled bank lending through "window guidance" (Hoshi, Scharfstein, and Singleton 1993).

The Basle Accord, an international agreement that set common standards by which to evaluate capital adequacy, was introduced in 1988. It tried to create a "level playing field" by requiring all internationally active banks to satisfy the same two (minimum) risk-based capital ratios: tier 1 (core) capital must be at least 4 percent of risk-weighted assets; and a broader measure, tier 2 capital, which includes tier 1 capital as well as subordinated debt and revaluation reserves (unrealized capital gains on equity security holdings), must be at least 8 percent of risk-weighted assets.