Deregulation, weak corporate governance contributed to systemic problems

• Pages: 87-89

Page 87

In the second half of the 1980s, Japan enjoyed above-trend economic growth and near-zero inflation. These conditions resulted in a significant decline in the country risk premium and a marked upward adjustment in growth expectations, which boosted asset price inflation fueled by credit expansion. At the time, Japanese banks were considered among the strongest in the world. During the same period, the pace of financial liberalization and deregulation accelerated, which spurred price competition and prompted banks and other depository institutions to take greater risks, including increased lending to the real estate industry. As land prices rose, these institutions loosened credit standards. In response, the authorities limited total bank lending to the real estate sector, curtailing the banks’ asset growth.

Asset prices peaked in 1989 and collapsed after the summer of 1990. Economic growth subsequently slowed and, along with the decline in stock and real estate prices, weakened banks and other financial institutions. By 1997, Japan was in the midst of a full-blown banking crisis. An IMF Working Paper by Akihiro Kanaya and David Woo, The Japanese Banking Crisis of the 1990s: Sources and Lessons, examines what went wrong and why it has taken the system so long to recover.

The Japanese banking crisis is a fitting subject for a case study, the authors say. First, most of its underlying causes are typical of banking crises in general. Second, it serves as a warning that even a seemingly robust and relatively sophisticated financial system like Japan’s is not immune to crisis. Third, it demonstrates that such a crisis can entail large costs for the country. In fact, according to Kanaya and Woo, a number of researchers attribute the stagnation of the Japanese economy in the 1990s in large part to the banking crisis.

What went wrong?

The working paper traces the problems in Japan’s banking system to the increased pace of deregulation and a deepening of the capital markets in the late 1980s, which overburdened the capacity of the system. Financial liberalization and deregulation took the form of a relaxation of interest rate controls; capital market deregulation, which included measures that made it easier for large corporations to borrow directly from the market; and a relaxation of restrictions on the activities of institutions that had previously been tightly segregated. For example, agricultural, fishery, and credit cooperatives were allowed to increase their lending to nonmembers.

These developments, Kanaya and Woo observe, had important implications for banks and other depository...