Section 2 Rebuilding Finance

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1. Importance of Non-performing Loan Disposal

blackcircle NPL problem and financial system

Non-performing loans are loans that are difficult to repay with future cash flow. NPLs can normally exist since it is always possible that some corporate borrowers will fail. Nevertheless, NPLs have been a serious problem in Japan for the following reasons.

First, many financial institutions have been plagued with massive NPLs, all together preventing indirect finance from working well. Even if some financial institutions are saddled with massive NPLs, sound ones may provide loans in their place to maintain indirect finance as a whole. If non-financial companies have access to direct finance, they may be able to raise funds through equity or bond issues and corporate finance as a whole may not be affected. In fact, however, most financial institutions now have been saddled with massive NPLs, and small and medium enterprises usually have little access to direct finance. Therefore, the NPL problem is directly linked to the financial system.

Second, doubts have emerged about the financial soundness of financial institutions. Japanese financial institutions have disposed of a huge amount of NPLs, but the economic slump and financial institutions' increased accuracy in asset assessment have led to the emergence of new NPLs. Financial institutions must dispose of NPLs swiftly as a matter of course. If their NPL disposal costs continue to exceed their profits from core banking operations, it may lead to a depletion of their capital base. If the people doubt the soundness of many financial institutions in the absence of prospects for any improvement in financial institutions' medium-term profitability, a financial system crisis may grow likely.

blackcircle Financial administration framework and NPL disposal

If Japan were to normalize indirect finance and rebuild finance, a framework would have to be developed to sustain and enhance the soundness of financial institutions. In this respect, the following points are important.

First, financial institutions must put into practice the three principles as embodied in the "framework of new financial administration" under the "Program for Financial Revival" that was announced on October 30, 2002. The principles are "Tightening assessment of assets," "Enhancing capital adequacy" and "Strengthening governance." It is primarily important for all financial institutions to appropriately assess loans and determine the correct amount of NPLs. In this respect, financial institutions' assessment of loans must be even stricter. If financial institutions were to write off NPLs steadily while maintaining their financial soundness, they would also have to recapitalize themselves as necessary. In addition, financial institutions must improve their risk management capacity and enhance cost-saving and profit-boosting efforts in order to prevent sound loans from becoming sour and ensure their financial soundness. In this respect, a framework is required to allow appropriate governance to work well for financial institution management.(9)

Second, financial institutions must dispose of NPLs quickly. Under the Financial Reconstruction Law, NPLs include loans to borrowers in legal bankruptcy or under restructuring (loans to bankrupt and effectively bankrupt borrowers under financial institutions' self-assessment rules), risky loans (loans to borrowers in danger of bankruptcy under financial institutions' self-assessment rules), and loans requiring special attention. The government has presented the following policies on the disposal of NPLs.

1) On loans to borrowers in danger of bankruptcy or worse, "Online of the Emergency Economic Package" in April 2001 included a framework calling for major banks to remove existing ones within two fiscal years and new ones within three years in principle (the "two-or-three-year rule").

2) In addition to the framework under "Online of the Emergency Economic Package", the Financial Services Agency's "measures for developing Stronger Financial System" in April 2002 urged major banks to remove 50% of such loans within one year and most (some 80%) of them within two years in principle (the "50%/80% rule").

3) In October 2002, the FSA's "Program for Financial Revival" said the FSA would strive to normalize the NPL problems by fiscal 2004 by reducing major banks' NPL ratio to about half (4% level) and would aim to create a stronger financial system that can support the structural reform.

Major banks have been disposing of NPLs in accordance with these policies.(10)

To what extent has the NPL disposal been implemented? What are the measures to further promote NPL disposal? We will now discuss these questions.

2. Present State of NPL Disposal and Relevant Problems

Since the major banks constitute the core of Japan's financial system, the government strives to normalize the NPLs problems in fiscal 2004 by reducing major banks NPL ratio to about half of fiscal 2001 and aims to create a stronger financial system that can support the structural reform. We will now consider the present state and problems regarding the major banks' disposal of NPLs.

(1) Present State of NPL Disposal

blackcircle Declining balance of NPLs

The balance of NPLs (based on the Financial Reconstruction Law) at the 11 major banks (including Resona Bank) remained at about ¥20 trillion between fiscal 1998 and 2000 before expanding to ¥26.8 trillion due to special inspections and other developments in fiscal 2001. In fiscal 2002, the balance declined 24.4% from the previous year to ¥20.2 trillion (see Figure 2-2-1). As a result, NPL ratio (to total credit) made up by NPLs fell by 1.2 percentage point from 8.4% in fiscal 2001 to 7.2% in fiscal 2002.

A breakdown of the balance in fiscal 2002 shows that Doubtful loans and Bankrupt or De facto Bankrupt loans, which correspond to loans to borrowers in danger of bankruptcy or worse, decreased by ¥6.7 trillion from the previous year.(11) Special Attention loans remained almost flat.

A major contributor to the fall in the balance of NPLs was an increasing removal of loans to borrowers in danger of bankruptcy or worse. Such loans removed in fiscal 2002 doubled from ¥5.2 trillion in the previous year to ¥10.8 trillion. Such loans that emerged in fiscal 2002 totaled ¥4.1 trillion, far less than the ¥9.0 trillion in fiscal 2001.

Figure 2-2-1 Major Banks' Outstanding Non-performing Loans and NPL ratio

blackcircle Forms and features of NPL removal from balance sheets

The removal of NPLs from balance sheets includes liquidation-oriented disposal, reconstruction-oriented disposal, reclassification of loans upon business improvements, liquidation, collection and repayment. Features of the removal of loans to borrowers in danger of bankruptcy or worse in fiscal 2001 and 2002 include the following (see Figure 2-2-2).

First, liquidation of NPLs increased. Liquidation of loans means selling loans to third parties. Usually, loans may be traded on the secondary market. In the absence of the development of a market for NPLs in Japan, market sales are limited. Actual sales include bulk sales of several NPLs and those to the Resolution and Collection Corporation.(12)

Second, reconstruction-oriented NPL disposal increased conspicuously. Direct NPL disposal includes liquidation- and reconstruction-oriented disposal.(13) The expansion of reconstruction-oriented disposal reflects increasing cases for reconstruction of companies under legal procedures based on the Civil Rehabilitation Law or the Corporate Reorganization Law, and out-of-court workout including loan waivers.

Third, the reclassification of loans upon business improvements also increased notably. Business improvements include improvements in the business performances of borrowers and upgrades of loan ratings. The recent increase is primarily attributable to the upgrades of loan ratings accompanying reconstruction-oriented disposal under out-of-court workout. In fact, upgrades of loan ratings accompanying reconstruction-oriented disposal accounted for 43% of NPL disposal upon business improvements, a sharp rise from the 5% in fiscal 2001.(14)

Figure 2-2-2 Measures for Major Banks' Removal of NPLs

blackcircle NPL disposal costs

We will now look at the changes in NPL disposal losses, or costs required actually for NPL disposal. NPL disposal losses are revenue transfers to loan-loss reserves and costs for direct loan disposal. They also include losses on loan sales in the market as well as additional loan-loss reserves to cover a decline in the value of loans and collateral. NPL disposal losses declined to ¥5.1 trillion in fiscal 2002 after expanding to ¥7.7 trillion in fiscal 2001. But these losses still exceeded effective core banking profits (see Figure 2-2-3).

While removed loans to borrowers in danger of bankruptcy or worse doubled from fiscal 2001 to 2002, NPL disposal losses declined. This may be because special inspections in fiscal 2001 prompted financial institutions to expand losses on heavy additions to loan-loss reserves in the year and allowed them to avoid new losses in fiscal 2002.(15)

Figure 2-2-3 Major Banks' Effective Core Operating Profit and NPL Disposal Losses

blackcircle Major banks' position in Japan's banking industry

How can the major banks' disposal of NPLs be positioned in such disposal for the whole of Japan's banking industry that also includes regional banks. In the first half of fiscal 2002, the major banks accounted for 60% of the approximately ¥40 trillion in NPLs at all Japanese banks. They also captured nearly 80% of cumulative NPL disposal losses for all banks between fiscal 1995 and the first half of fiscal 2002 (see Figure 2-2-4). The major banks have thus had and disposed of more NPLs than regional banks.

Figure 2-2-4 NPLs at Japanese Banks

(2) Problems with NPL Disposal

blackcircle NPL ratio-halving target

The government is trying to resolve the NPL problem under its NPL ratio-halving target that urges the major banks to halve their shares of NPLs to their total outstanding loans in fiscal 2004 to about a half of the fiscal 2001 level of 8.4%.

The government policy has apparently been reflected in the major banks' business plans.(16) Their NPL ratio at the end of March 2003 stood at 7.2%, down 0.9 percentage point from the 8.1% at the end of September 2002. The NPL ratio, if reduced at this pace, could fall to the 4% level by the end of fiscal 2004, which would mean the attainment of the NPL ratio-halving target.

In order to project future progress in NPL disposal, we will now check whether the major banks made any greater progress in fiscal 2002 than in the past. Specifically, we use the major banks' published transition matrix of borrowers categories (that indicates borrowers' move from one category to another within a certain period) for fiscal 2000 to estimate fiscal 2002 category-wise NPLs for the case where loans move from one category to another in the same pattern as in fiscal 2000. Then, the estimates are compared with the actual results for fiscal 2002 (seen Table 2-2-5).(17)

The comparison showed 1) that actual new NPLs stood at ¥5.0 trillion, above the ¥4.4 trillion estimated through the transition matrix. But it indicated 2) that actual loans to borrowers in danger of bankruptcy or worse totaled ¥8.7 trillion, below the estimated ¥9.7 trillion, 3) actual Special Attention loans totaled ¥11.5 trillion, below the estimated ¥13.1 trillion, and 4) the actual NPL ratio came to 7.2%, below the estimated 7.6%. Most of the actual results were thus better than the estimated baselines.

This demonstrates that while stricter asset assessment under special inspections led to relatively more new NPLs, the major banks made more progress in fiscal 2002 than earlier.

Table 2-2-5 Transition Matrix of Borrower Categories

blackcircle Tackling loans to Need Attention and Special Attention borrowers

The major banks must further accelerate their NPL disposal in order to lower their NPL ratio 4% level. They are disposing of loans to borrowers in danger of bankruptcy or worse under the existing government policy. The key to the attainment of the NPL ratio reduction goal may be to tackle loans to Need Attention and Special Attention borrowers as well as the existing loans to borrowers in danger of bankruptcy or worse.

The first reason for the major banks to tackle loans to Need Attention and Special Attention borrowers is that most of loans that have been moved out from the category of loans to borrowers in danger of bankruptcy or worse due to borrowers' business improvements involving reconstruction-oriented NPL disposal still need management within the NPL category. Such loans have increased due to the increasing reconstruction-oriented NPL disposal as outlined earlier. As progress is made in disposing of loans to borrowers in danger of bankruptcy or worse, it is growing more important for borrowers needing management to select profitable business areas so that they can reinvigorate quickly.

Second, new NPLs may emerge if borrowers that are sound or need attention are downgraded due to financial deterioration. In order to avoid new NPLs, the major banks must prevent the deterioration of loans to sound borrowers and improve risk management for loans to borrowers needing attention.

blackcircle Financial institutions must improve profitability

Before the collapse of the bubble economy, financial institutions had been able to take advantage of abundant funds raised at low costs and rising prices for real estate as collateral to offer lending rates that might not meet risks involved in loans to companies. If financial institutions' risk-tolerance capacity declined with corporate borrowers' credit risks growing higher after the collapse of the bubble economy, however, financial institutions should have set their lending rates at levels meeting risks. As explained earlier, the major banks' NPL disposal costs have exceeded their core banking profits. They should set lending rates at risk-meeting levels in order to improve their profitability and raise resources for NPL disposal.(18)

We will now discuss the recent relationship between credit risks and borrowings rate gaps using corporate borrowers' data. If lending rates were set to meet risks, rate gaps should have emerged between low- and high-risk borrowers. The data indicate that lending rate gaps widened in accordance with long-term debt ratings from fiscal 2000 to 2002 (see Figure 2-2-6).

Since the data are limited, we look now at gaps between interest rates only on short-term borrowings for listed companies that have long-term debt ratings. The gaps might be even wider between long-term rates and between rates for blue chip companies and firms that have no debt ratings. The widening lending rate gaps are expected to help financial institutions to improve their profitability.(19)

Regarding profitability, the major banks are also faced with the problem of recoverability of deferred tax credits that account for about half of their Tier 1 core capital(20) (see Figure 2-2-7). While deferred tax assets are dependent on future taxable profits, financial conditions have remained severe for the major banks, which have continued to suffer net losses.

In order to project sufficient profits for the future, financial institutions are required to boost their profitability and work out future financial plans that can withstand strict assessment. While being required to attain the NPL ratio-halving target, the major banks are faced with a difficult challenge to earn profits that exceed their losses on NPL disposal and on equity share write-offs and sales.

Figure 2-2-6 Firms' Creditworthiness and Fund-raising Cost

Figure 2-2-7 Breakdown of Major Banks' Core Capital

blackcircle Halving NPL ratio

Given the problems outlined above, in order to halve their NPL ratio as scheduled, major banks must 1) try to improve assets qualitatively by stepping up the revival of corporate borrowers and the liquidation of unprofitable assets and 2) improve profit margins on lending and reduce overall costs to secure resources for NPL disposal.

As for the improvement of assets, some major banks have enhanced their asset-assessment systems, established NPL management firms under holding companies and launched business turnaround funds to integrate NPLs and human resources to accelerate the selection of businesses and NPL disposal. In addition to these efforts of major banks, Japan should actively exploit the Industrial Revitalization Corporation of Japan and business turnaround frameworks and develop and use a private sector-led NPL trading market.

These challenges are mostly linked closely to rebuilding enterprises. This will be discussed in Section 3.

3. Financial Incentive Structure

blackcircle Incentive structure impeding normalization of indirect finance

Japanese financial institutions have provided company-based loans rather than project-based loans while maintaining long-term relationships with corporate borrowers. In accordance with such lending practice, they have categorized corporate borrowers into the following four types for management of loans: (1) normal borrowers; (2) borrowers needing attention; (3) borrowers in danger of bankruptcy; and (4) de facto bankrupt and bankrupt borrowers. Sales of loans had not been conceivable in Japan.

The traditional Japanese lending practice has no problems as long as finance is able to work well under the sustainable long-term relationships between financial institutions and corporate borrowers. At a time when the NPL disposal has become a major challenge for financial institutions, however, the traditional lending practices could have given financial institutions an incentive to delay NPL disposal. Under the company-based lending practice, financial institutions may be sometimes required to liquidate corporate borrowers in order to dispose of NPLs. But financial institutions may hesitate to liquidate corporate borrowers and choose to give them additional loans since they usually hold equity stakes or some other investments in corporate borrowers, have some subordinated loans to them and fear social criticism about job losses resulting from corporate liquidations.

Such financial incentive structure should be changed in order to normalize indirect finance. Institutional and framework changes cannot work well unless the incentive structure is reformed.

We would now like to analyze some moves that could lead to reforming the incentive structure. Specifically, we deal with 1) transfer of loans, 2) unwinding of cross shareholdings and 3) review of policy-based finance.

(1) Transfer of Loans

blackcircle Advantage of loan transfer

Under the traditional lending practices based on continuous and stable relations between financial institutions and corporate borrowers, neither had considered financial institutions' sales of loans to third parties. Sales of loans have been legally allowed unless provided otherwise in special clauses attached to lending contracts. In practice, however, sales and disclosure of loans have been subjected to approval by borrowers.(21)

If financial institutions are allowed to transfer credit risks to third parties including other financial institutions in accordance with their own risk tolerance capacity, it may contribute to the facilitation of fund flow and the stabilization of the financial system. This is because financial institutions with relatively high risks can improve their safety while those with relatively low risks can take additional ones to build appropriate portfolios.

blackcircle Significance of market-oriented indirect finance

Against the background outlined above, moves have emerged to create a loan trading market. For example, syndicate loans whose terms and conditions are required to be objective and transparent may be typically marketable and negotiable on such a market.(22)

An increase in loans that are initially designed for sale to third parties could lead to the expansion of market-oriented indirect finance. Market-oriented indirect finance means a system where loans provided by financial intermediaries and financial products bought by them have liquidity on the market and can be traded widely. Financial institutions that have so far converted risks only on their respective balance sheets could improve the efficiency of finance's risk conversion function by transferring risks to investors who can afford to take risks on the capital market. If conditions are developed to allow loans to be sold not only to financial institutions but also to a diverse range of other investors willing to invest their funds, it may contribute to facilitating fund provision.(23)

blackcircle Moves to liquidate assets

In recent years, the balance of liquidated assets has been increasing (see Figure 2-2-8). As well as financial institution loans, installment claims and deposits have been growingly liquidated. This indicates that asset liquidation has been playing a key role in allowing financial and non-financial companies with financial assets to raise funds.

Figure 2-2-8 Progress in Liquidation of Assets

On the other hand, non-financial enterprises have been boosting holdings of securities for liquidated financial assets faster than financial institutions. This means that non-financial enterprises have been providing funds in a manner to offset a fall in banks' loans. At the same time, it indicates that liquidated assets could be accepted as general investment options more and more (see Figure 2-2-9).

Figure 2-2-9 Bank Lending and Asset Liquidation

(2) Unwinding of Cross Shareholdings

Relations between financial institutions and their corporate customers under the main bank system have been changing.(24) Furthermore, financial institutions and their corporate customers have been unwinding their cross shareholdings. These changes are expected to allow financial institutions and their corporate customers to have arm's-length relations.

The stability of shareholders through cross shareholdings between financial institutions and their corporate customers had worked to forestall takeover bids. But the unwinding of cross shareholdings can increase their floating shares, leading to a higher possibility of these non-financial companies becoming takeover targets. These firms have thus had to increase shareholder value and increase share buybacks(25) and investor relations activities in place of cross shareholdings, as a defensive measure against takeover bids.

These changes have provided enterprises with an incentive to consider utilizing direct finance much more than in the past.

(3) Review of policy-based finance

Policy-based finance has used postal savings and other funds for policy purposes to provide long-term, fixed-rate and lower-rate loans to small and medium enterprises, infrastructure development and other risky areas that private finance cannot cover fully. It has undoubtedly contributed to Japan's economic development (see Figure 2-2-10).

On the other hand, massive NPLs and excessive debts have prevented Japan's present financial system from allowing abundant funds to flow smoothly and efficiently to growth sectors. This has become a serious problem. In order to resolve it, Japan must promote structural reform to direct funds to growth sectors featuring efficiency and social needs, and enhance the system whereby funds are allocated in accordance with market forces.

Specifically, private financial institutions are required to dispose of NPLs, set lending rates that meet the credit risks of corporate borrowers and develop new business models for improving profitability. On the other hand, policy-based finance must support these efforts of private financial institutions to allow market forces to work in a full-flown manner. At the same time, policy-based finance targets must be reviewed under the principle that what the private sector can do should be left to it to be done.

At its meeting on December 13, 2002, the Council on Economic and Fiscal Policy(26) acknowledged that Japan's policy-based finance has been larger in size than in other countries and has tended to increase, helping to distort the resource allocation functions of financial and capital markets. It then concluded that Japan should implement a three-stage policy-based finance reform(27) in view of the current difficult financial and economic conditions in order to normalize the private sector's financial functions. Based on the conclusion, the government has been reviewing policy-based finance while watching the economic situation.(28)

Figure 2-2-10 Changes in Policy-based Financial Institutions' Outstanding Loans and Ratio to Nominal GDP

4. Rebuilding Finance

We have now considered how the functions of indirect finance have declined in Japan, the present state of the NPL problem that must be resolved, and the importance of the incentive structure for the normalization of financial functions. We will now review these points and present the conditions for rebuilding finance.

blackcircle Normalizing indirect finance

The present decline in the functions of indirect finance is linked to both the decrease in NPL-plagued financial institutions' risk-tolerating capacity and the rising credit risks of borrowing enterprises plagued with excessive debts. We believe that these problems have worked to prevent abundant funds on the money market from flowing throughout the economy, resulting in a drop in loans by financial institutions to enterprises.

At a time when there is growing interest in credit risks, however, the role of indirect finance-where financial institutions provide loans while monitoring management of corporate borrowers-is even more important. This is because small and medium enterprises limit their information disclosure and have difficulties in raising funds through securities issues, which larger enterprises can do easily.

In order to normalize indirect finance, Japan must promote NPL disposal and build an appropriate incentive structure.

blackcircle Promoting NPL disposal

NPL disposal has been making progress. In order to halve the NPL ratio, however, the major banks must further accelerate NPL disposal. Relevant challenges include the strict response to loans to Need Attention and Special Attention borrowers, and the prevention of new NPLs.

Financial institutions are required to improve their profitability in order to promote NPL disposal. Specifically, they should 1) improve profit margins on loans and save costs to secure resources for NPL disposal and 2) improve assets qualitatively through early turnaround of corporate borrowers and liquidation of unfavorable assets.

As for the qualitative improvement of assets, the major banks' efforts must be coupled with the utilization of the Industrial Revitalization Corporation of Japan and other business turnaround frameworks, and the private sector-led development of an NPL trading market. In this way, effective measures must be taken to reduce the ratio of NPLs to total outstanding loans.

blackcircle Building appropriate incentive structure

The resolution of the NPL problem depends on incentives for relevant parties to make such efforts.

A mechanism that encourages financial institutions to promote the enhancement of their risk management capacity, including stricter assessment of assets, is required to prevent the present ultra-low interest rates from becoming an incentive to delay NPL disposal. The government has put into practice the "new financial administration framework." The business turnaround framework which will be discussed in the next section, has been developed to give relevant parties appropriate incentives.

If the obstacles to the sale of sound loans are removed, increasing their liquidity, NPL trading and loan transactions with prospects for secondary resale may increase. If the way is paved for project finance through syndicate loans, disposal of new NPLs may be accelerated. Fund-raising needs may be tending to increase the liquidation of assets. This tendency will serve to expand the range of financial functions.

Unwinding of cross shareholdings and other moves could allow some financial institutions and their corporate customers to have more arm's-length relations. This could give non-financial companies an incentive to use direct finance.

Policy-based finance targets should be reviewed continuously under the principle that what the private sector can do should be left to it to be done.

These moves may contribute to accelerating the resolution of the NPL problem and normalizing indirect finance.

The efforts as cited above are expected to help to rebuild finance in Japan. However, the problem of finance is closely linked to the problem of corporate borrowers. In the next section, we will look at the present state of and challenges for rebuilding enterprises.

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