RDP 2000-03: Some Structural Causes of Japan's Banking Problems 2. Historical Background

Private domestic banks have intermediated a high proportion of Japanese corporate finance throughout most of the postwar period. Data reported by Hamada and Horiuchi (1987) indicate that, on average, their loans accounted for about three-quarters of all externally sourced industrial funds between 1947 and 1972. Table 1 shows that they also managed, and continue to manage, a high proportion of household savings.

The importance of the banking system in Japanese industrial finance dates back at least to the early postwar period, when household financial wealth was low, and the diversification of risk through the stock market was prohibitively expensive. The attractions of financial intermediation in such an environment were enhanced by the (then) acute problems of maturity transformation and the need for a viable system of corporate governance (Hamada and Horiuchi 1987; Hoshi, Kashyap and Scharfstein 1993).

Financial regulation validated banks as a solution to these problems and promoted their role in both corporate finance and governance. It limited entry to the banking market, and it effectively restricted securities market access to long-term credit banks, public utilities, and a handful of manufacturers. Through a comprehensive web of regulations and through the tax structure, it also discouraged reliance on equity finance. And finally, it preserved the pre-war philosophy of financial market segmentation. Among other things, regulation partitioned rural and urban banking, commercial and trust banking, long-term and short-term financing, and it separated the various types of securities business from other forms of finance.

From the mid-1970s, aspects of this structure began to change (Table 2). Initially, borrowed capital gave way to internally generated funding as a major source of finance among larger firms. Then, during the 1980s, the declining dependence of major corporations on bank loans accelerated, as the deregulation of securities markets facilitated bond finance.

Patrick (1999) argues that these changes in the corporate finance environment were closely related to several macroeconomic developments that date from the 1970s. The first of these was a slowing rate of real economic growth (Figure 1). By the early 1970s, domestic investment opportunities had become somewhat scarcer, causing the retained earnings of larger corporations to rise and their financial deficits to fall (Table 2). This represented a significant threat to the market share and operating income of the banking sector, which depended heavily on interest income from loans to non-financial corporations. Banks regarded the liberalisation of their lending markets as a means of restoring their competitiveness and reasserting their market share of the total flow of funds (Cargill and Royama 1992).

Concurrent with the slowing growth rate was a steady increase in the current account surplus. When growth fell and investment declined, the current account surplus rose (Figure 1). As Argy (1987) points out, the implied capital outflows had to be accommodated with a more flexible capital account structure. This was particularly pressing for banks and larger non-financial corporations, both of which were managing larger flows of foreign exchange. As explained in more detail below, this provided the impetus for the relaxation of some capital controls, and it paved the way for deregulation of the domestic securities markets.

The other important macroeconomic development of the 1970s was the sharp increase in public sector indebtedness. In the late 1960s and early 1970s, the Japanese government increased public works expenditure significantly. Shortly afterwards, non-discretionary expenditure also increased, as Japan encountered what was then its most serious postwar recession. The combined effect of these processes was a large increase in public sector debt. The deficit of the total public sector increased from one per cent of GDP in 1970 to 7.3 per cent in 1975. The Bank of Japan monetised little of the debt, and so private sector bond holdings increased substantially.

At this time, government bonds were effectively allocated to a syndicate of banks on terms that were set by the Ministry of Finance. The increase in their issuance, coupled with a rise in inflation, squeezed banks' real margins and led to lobbying for the development of more effective secondary markets: a demand to which the government acquiesced. Before 1977, fewer than five per cent of national bonds were sold on the Tokyo secondary market; by 1982, that ratio had risen to 62 per cent (Hamada and Horiuchi 1987, p 28).

The liberalisation of the government bond market proved contagious, forcing the creation of a market in negotiable certificates of deposit in 1979 and the eventual liberalisation of the money markets. Partial liberalisation of government bond trading in 1977 had caused a marked increase in the size of the gensaki market for short-term repurchase agreements in government bonds, and this produced a significant change in the wholesale funds market. Faced with a loss of market share, banks lobbied (again successfully) for the progressive liberalisation of alternative money market and deposit instruments.

And so, by the late 1970s, Japan's autarkic and regulated corporate financial system had come under considerable pressure from some lasting and significant macroeconomic changes. By the end of the decade, the banks – whose interests the system had been designed to protect – were pressing for reform.