ECONOMIC RESEARCH CENTERDISCUSSION PAPER
E-Series
No.E12-5

Japanese Banking Regulations under a Series ofFinancial Crises Since the 1990s
byNobuyoshi Yamori
Kazumine Kondo
Kei Tomimura
Yuko Shindo

October 2012

ECONOMIC RESEARCH CENTERGRADUATE SCHOOL OF ECONOMICSNAGOYA UNIVERSITY

Japanese Banking Regulations under a Series of Financial Crises
Since the 1990s
Nobuyoshi Yamori, Nagoya University
Kazumine Kondo, Aichi Gakuin University
Kei Tomimura, Aichi University
Yuko Shindo, Yamaguchi Prefectural University

September 30, 2012

Abstract
This paper discusses the current state of regulations and supervisions of Japanesebanks, which have experienced and evolved through two crises – the post-bubble
financial crisis which took place around 2000, and the global financial crisis whichstarted in 2007. Firstly, the state of Japan's banking industry will be discussed in
section 2. In section 3, an outline of Japan’s banking regulations will be discussed. Then,in section 4, the financial system reforms that were implemented to address thepost-bubble financial crisis will be explained. In section 5, an explanation detailing the
new trend in financial regulations that respond to the global financial crisis will be
provided. Finally, section 6 presents the conclusion.

Key words
Banking Regulation, Financial Crisis, Japanese Banks, Bank Supervision.

1. Introduction
In the 1980s, Japanese financial institutions increased their presence in Western
financial markets. Japanese financial institutions had close business relationships withlarge Japanese corporations (interlocking keiretsu business relationships) and suffered
few nonperforming loans because of the country’s steady economic development, making
1them the soundest financial institutions in the world. Table 1 shows the transition in
the credit rating of major Japanese financial institutions and demonstrates that in 1988,
many Japanese financial institutions were given a top credit rating.
However, in the 1990s, the financial condition of Japanese financial institutions
deteriorated rapidly as a result of an increase in nonperforming loans brought on by aneconomic slump. For example, Figure 1 shows the changes in the balance of
nonperforming bank loans that Japanese banks held. At its peak in 2001, this levelexceeded ¥40 trillion. Figure 2 clearly indicates the severity of the problem, and Figures
2 and 3 show that, despite disposing of nonperforming loans exceeding ¥10 trillion
every year in the late 1990s, the balance of nonperforming loans still increased.
In 1997, the financial condition of major banks grew severe, as evidenced by the failureof institutions such as Hokkaido Takushoku Bank, which had a significant standing
within major commercial banks, and Yamaichi Securities, one of the four major security
corporations. As described later, financial institutions that survived with government
assistance barely escaped bankruptcy.
In the past, Japanese banks were subjugated under extremely strict regulations
implemented by the Ministry of Finance. In the 1980s, however, financial globalization
progressed, increasing the concern that if the regulations did not change, they may
promote the hollowing out of the domestic markets. From 1996, the Japanese
government advocated Japanese “Big Bang” financial reforms, and fundamentally
restructured the regulations. These reforms could have been viewed as a “constructive”
approach to financial regulations for a new economic environment.
On the other hand, the deterioration of the business conditions of financial
institutions progressed at a speed and scale greater than what was anticipated. Because
the laws that addressed such a situation were inadequate, financial regulators wereforced to respond in an ad hoc manner, tackling each financial problem encountered by
the major financial institutions as it occurred. After this trial-and-error approach of ten
or more years, the restructuring of the regulations was almost completed by around
2005.

2

The financial regulation reforms, aimed at dealing with the financial crises in Japanthat took place after the bubble economy collapsed (hereinafter referred to as thepost-bubble financial crises to distinguish it from the global financial crises since 2007,
which will be mentioned later), initially were passive in nature. However, these reforms
enhanced the crisis-response capabilities of Japan’s financial system.
During the global financial crises that plagued the entire world from 2007 onward,
Japan’s financial system did not encounter major problems, and the distrust in thesoundness of financial institutions did not intensify among the general public. The
Japanese economy was certainly confronted with severe economic afflictions resulting
from a major decline in exports. However, unlike in the post-bubble financial crisis, theeconomic difficulties were not attributable to the financial system. In this sense, Japan’s
financial system had become equipped with crisis response capabilities.
However, since the financial markets are becoming globally unified, each country’s
financial regulations need to be mutually consistent. Specifically, the results of financial
regulation reforms in countries like Europe and the U.S. indicates that Japan’s
financial regulators have to modify the domestic regulations. Eventually, they are
considering the modification of capital adequacy regulation as the Basel III has been
agreed as the new international rules.
This paper will discuss the current state of regulations and supervisions of Japanesebanks, which experienced and evolved through two crises – the post-bubble financial
crisis which took place around 2000, and the global financial crisis which started in
20071. Firstly, the state of Japan's banking industry will be discussed in section 2. In
section 3, an outline of Japan’s banking regulations will be discussed. Then, in section 4,
the financial system reforms that were implemented to address the post-bubble
financial crisis will be explained. In section 5, an explanation detailing the new trend in
financial regulations that respond to the global financial crisis will be provided. Finally,
section 6 presents the conclusion.
More technical analyses are conducted in Ogura and Yamori (2010), Yamori andHarimaya(2009, 2010a, 201b), Yamori, Harimaya, and Asai (2006), Yamori and Okada(2007), Yamori, Tomimura, and Harimaya (2011). Also, many studies analyzes Japanesebanking (e.g., Hall[1999, 2003, 2007], Honda [2002], Uchida and Udell[2010]).
1

3

Table 1
Japanese Banks’ Credit Ratings (Moody’s Credit Rating)
1988

Aaa

Aa1
Aa2
Aa3

Dai-Ichi Kangyo,
Sumitomo, Fuji,
Mitsubishi, IBJ,
Norinchukin
Sanwa, Mitsubishi Trust,
Sumitomo Trust
Tokai, Tokyo, LTCB,
Mitsui Trust
Yasuda Trust, Toyo
Trust, Yokohama,Shizuoka

1993

1998

Shoko Chukin

Mitsubishi, Sanwa,
Tokyo, IBJ, Shoko
Chukin, Shizuoka

Shizuoka, Shoko Chukin

A1

Dai-Ichi Kangyo,
Sumitomo, Fuji,
Norinchukin

Sanwa, Tokyo
Mitsubishi, Norinchukin

A2

Sakura, Tokai, Asahi

Sumitomo, Nippon Trust

A3

Daiwa, LTCB,
Yokohama

Dai-Ichi Kangyo, IBJ,
Yokohama

Mitsubishi Trust,
Sumitomo Trust, Toyo
Trust
Hokkaido Takushoku(Takugin), Nippon
Credit, Mitsui Trust,
Yasuda Trust, Chuo
Trust, Nippon Trust

Sakura, Fuji, Toyo Trust,
Sumitomo Trust, Asahi,
Tokai

Baa1

Baa2

2006 (as of end
November)

Baa3

4

Norinchukin, Mitsubishi
Tokyo UFJ, Sumitomo
Mitsui, Shizuoka,
Mizuho Corporate, Chuo
Trust
Higo, Sumitomo Trust
Shinsei, Resona, Chuo
Mitsui Trust, Mitsui
Asset Trust, Yokohama
Aozora, Suruga,
Hiroshima, San-In Godo

Mitsui Credit

Nishi-Nippon City,
Ogaki Kyoritsu, Kiyo,
Hokuriku, Hokkaido,
North Pacific

Nippon Credit, Hokkaido
Takushoku, Chuo Trust,
Yasuda Trust, Daiwa,
LTCB

Ashikaga

Figure 1
Changes in the Balance of Nonperforming Bank Loans
45 trillion yen
40
35
30
25
20
15
10
5
0
1992

1994

1996

1998

2000

2002

2004

2006

2008

Note: The figure shows the risk management loans of banks at the end of each fiscal
year (i.e., March 31). The statistics coverage has expanded in 1995 and 1997.

Figure 2
Changes in the Total Losses on Disposal of Nonperforming Bank Loans
16
14trillion yen

12
10
8
6
4
2
0
1992

1994

1996

1998

2000

2002

5

2004

2006

2008

2. Overview of the banking industry in Japan22-1. Types of banks
Figure 3 shows the basic structure of the banking industry in Japan.
Private banks can be divided into several categories based on such factors as business
function or historical background. The distinction among city banks, regional banks,and member banks of the Second Association of Regional Banks (regional banks II) is
not a legal one, but is a customary classification for the purposes of administration andstatistics. City banks are large in size, with headquarters in major cities and branchesin Tokyo, Osaka, other major cities, and their immediate suburbs. Regional banks areusually based in the principal city of a prefecture, conduct the majority of theiroperations within that prefecture, and have strong ties with local enterprises and local
governments. Like traditional regional banks, regional banks II serve smaller
companies and individuals within their home regions. Most of these banks converted
from mutual savings banks into ordinary commercial banks in 1989.
In addition to these commercial banks, there are cooperative financial institutions,
including credit associations (Shinkin banks) and Agricultural Cooperatives. These
financial institutions are established to serve certain sectors. For example, credit
associations are mainly engaging in providing loans to small- and medium-sizedenterprises (SMEs), and Agricultural Cooperatives serve farmers.
Finally, Japan Post is a unique financial institution. The government ran the postal
savings system until 2007, when Japan Post was established as a private stock company.
However, the government still fully owns the stock of Japan Post, and most Japanesedepositors regard Japan Post as a public-supported institution.
Figure 4 shows relative shares of these financial institutions regarding fund-raisingand loans.

See Yamori and Nishigaki (2008), which describes the large changes that haveoccurred in the financial system since the 1990s as well as the impacts of those changes
on banks, and discusses the new challenges for Japanese banks.
26

Figure 3
Banking Industry Structure in Japan
Centra l Ba nk

Ba nk of J apan

Private fi nancia l

Depositor yinsti tutions

insti tutions

Banks

City banks (6)Regional ba nks (64 )M enber ba nks of the Sec ond Associa tionofRe giona l Ba nks (44 )For eign ba nks (61 )Trust b anks (19)Other s (1 4)(Ba nk hold ing comp anies (1 2))
Cooper at ive-ty pe

Shinkin Centr a l Bankfina nci al institut ions

Shinkin banks (279 )Shinkumi Fed era tion Ba nk
Credi t coop eratives (162 )Rokinren Ba nk
La bor b anks (1 3)
N orinchukin Ba nk
Credi t fe derations of a gr icultural
c ooper atives (36 )Agr icultural coo per ati ves
Credi t fe derations of(7 40 )

fisheryc ooper atives (30 )Fishe ry coopera tiv es (1 68 )Other fina nc ial

Insurance com pa nies

institutions

Life insurance compa nies
N on- life insurance co mpa nies

Securi ties firms
Pub lic financia lGove rnment fina ncial

Ja pa n Financial

Ja pa n Bank

insti tutions

insti tutions

Corp ora tion

for Internati ona l
Cooper at ion ((JBIC)

Okina wa Devel opm ent
Fi nance Corp ora tion
J oint c orp or aio n by

J apan F ina nc e Orga nizationloca l g overnme nt s

for Munici pa lities
Dev elop ment Bank of Ja pa n Inc .
The Shoko Chukin Bank, Ltd .*J apan Po st Ba nk Co. *J apan Po st Insurance Co.*

Note: Figures in parentheses represent the number of financial institutions in eachcategory basically as of April 1, 2009.
(source：Japanese Bankers Association)
7

Figure 4
Market Share of Financial Institutions (%, as of the end of 2008)(1) Fund raising (Total ¥1241 trillion)
financial
institutions
postalforsavings, 14.4
agriculture
forestry andfishery, 7.4

financial
institutions
for small- andmediumsizedbusinesses,
13.2

city banks,
21.9
regionalbanks, 16.4

trust
accounts,
16.0

memberbanks of theSecondAssociation ofRegional
Banks, 4.6

foreigntrustbanks, 0.8 banks, 5.2(2) Loans (Total ¥701 trillion)
financial
institutionsforagriculture
forestry andfishery, 5.7
financial
institutions
for small- andmediumsizedbusinesses,
trust
14.2
accounts,
0.8
trust
foreignbanks, 6.2
banks, 1.1

government
financial
institutions,
15.8
city banks,
27.9

regionalbanks, 22.0
memberbanks of theSecondAssociation ofRegional
Banks, 6.2

Notes:(1) Funds include deposits, debentures and trusts.
(source:：Bank of Japan)8

2-2. Merger and Integration of Japanese banks in the 2000s
In the 2000s, a succession of mergers and integrations occurred over a short period oftime to create “Mega Banking Groups” such as the Mizuho Financial Group, Mitsubishi
UFJ Financial Group and Sumitomo Mitsui Financial Group. (See Figure 5 for details.)
These mergers and integrations were made possible by the modification of the legal
and tax system, which enable banks to undergo large-scale organizationaltransformations, in addition to the drastic changes in the management environment
requiring banks to deal with non-performing loan problems and cope with international
competition. These industry-wide reorganizations were not limited to major banks but
also spread to regional banks, resulting in the establishment of holding companies insome cases which cover regions broader than before.
Because of the mergers and acquisitions as well as failures, the number of banks
continues to decrease in the 2000s (See Table 2). The average size of existing banks has
inevitably increased.

9

Figure 5
Mergers and Integrations among City Banks, Long-term Credit Banks and Trust Banks

2 000,9Dai-Ichi K angyo Bank
Fuji Bank
Industrial Bank of Japan
Mizuho Trust*

2002,4

2003,3

Mizuho Holdings

Mizuho Holdings

D ai-Ichi K angyo Bank

Mizuho Bank

Mizuho Financial Group
Mizuho Bank

Fuji Bank

Mizuho Corporate Bank

Mizuho Corporate Bank

Industrial Bank of Japan

Mizuho Trust

Mizuho Trust

Mizuho Trust

2001,4

2002,12

S umitomo Mitsui Banking Corp,

Sumitomo Mitsui Financial Group

Sakura Bank

Sumitomo Mitsui Banking Corp,

Sumitomo Bank

2001,4

2001,10

2005,10

Mitsubishi Tokyo Financial Group

Mitsubishi Tokyo Financial G roup

Mitsubishi UFJ F inancial GroupBank of Tokyo-Mitsubishi

Bank of To kyo-Mitsubishi

Bank of Tokyo-Mitsubishi UFJ

Mitsubishi Trust

Mitsubishi Trust

Mitsubishi UFJ Trust

Bank of Tokyo-Mitsubishi
To kyo Trust*
Mitsubishi Trust

Nippon Trust

Nippon TrustTokyo Trust

2001,4
Sanwa Bank
Tokai Bank
To kai Trust*Toyo Trust

2002,1UF J Holdings

UFJ Holdings

Sanwa Bank

UFJ Bank

Tokai Bank

UFJ TrustToyo Trust
Tokai Trust

2001,12
Daiwa Bank

2002,10

2003,3

Daiwa Bank Holdings

Resona Holdings

Daiwa Bank

Daiwa Bank

Resona Bank

Kinki Osaka Bank**

Asahi Bank

Saitama Resona Bank

Nara Bank**

Kinki Osaka Bank**

Kinki Osaka Bank**

Nara Bank**(Nara Bank**)****

Daiwa Trust(Resona Trust)****

2002,3Asahi Bank

Resona Holdings

Asahi Trust*

2000,4Mit sui Trust
Chuo Trust

2002,2Chuo Mit sui Trust

Mitsui Trust Holdings

Sakura Trust*

2007,10Chuo Mitsui Trust Holdings

Chuo Mitsui Trust

Chuo Mitsui Trust

Mitsui Asset Trust

Chuo Mitsui Asset Trust* trust bank subsidiary** regional bank*** The date of merger was January 1, 2006.
**** The banks were merged into Resona Bank.

(source：Japanese Bankers Association)

10

Table 2
Changes in Number of Banks
end of March

1990

1995

2000 2002

2003 2004

2005

2006

2007

City Banks

13

11

9

7

7

Regional Banks

64

64

64

64

Regional Banks Ⅱ

68

65

60

Trust Banks11623Long-term Credit Banks

3

Other banks2-2008 2009

7

7

6

6

6

6

64

64

64

64

64

64

64

56

53

50

48

47

46

45

44

33

29

27

27

26

23

21

20

20

3

3

3

2

2

1

1

0

0

0

-

-

5

5

6

9

9

10

13

14

1. including foreign-owned trust banks
2. including the Second Bridge Bank of Japan and the Resolution and Collection
Corporation(source：Japanese Bankers Association)

2-3. Entry of new-type banks
From 1999, non-financial institutions began to enter the banking business by
establishing new types of banks such as banks specializing in settlements or Internet
banks, which include Japan Net Bank (starting its operation in October 2000), IY Bank(presently, Seven Bank)(May 2001), Sony Bank (June 2001), eBank (July 2001), SBI
Sumishin Net Bank (September 2007), AEON Bank (October 2007), and Jibun Bank
(July 2008). In addition, banks focusing on lending to SMEs and start-up companies
started their operation, including Nippon Shinko Bank (or, Incubator Bank ofJapan)(April 2004), and ShinGinko Tokyo (April 2005)3.
The entry of non-financial entities into the banking business led to an amendment to
the Banking Act concerning the regulation of bank shareholders from April 2002.
Namely, shareholders of more than 5% of a bank’s total shares must file with the3

Nippon Shinko Bank failed in 2010 due to huge bad loans.
11Financial Services Agency (FSA), and those seeking to hold 20% or more need the FSA‘spermission to acquire the shares and are subject to FSA’s inspection.

3. Current banking regulations in Japan
3-1. Brief historical development of banking regulation and supervision
Japan’s financial administration has gone through major changes since 1990.We
discuss the transition of Japan’s financial administration here by categorizing thesechanges into three stages.
The first stage occurred approximately between 1997 and 2002, when theadministration was pressured with addressing difficulties of financial system. In 1997,
Hokkaido Takushoku Bank and Yamaichi Securities went bankrupt, followed by thecollapse of the Long-Term Credit Bank of Japan (LTCB) and Nippon Credit Bank (NCB)
in 1998. Despite the government having responded by making a ¥10 trillion capital
injection and providing full protection on bank deposits, which was called the freeze on
the “payoff system” in Japan, it was a period where concerns regarding the soundness ofmajor commercial banks spread in an unprecedented manner.
It was a period in which the reorganization of information disclosure system, thetightening of asset evaluation which formed the basis of the information disclosuresystem, and a system of prompt corrective action were introduced in order to accurately
capture the state of financial institutions. In this sense, it was the period where thefinancial administration began to depart from its traditional form. Furthermore, thefinancial legislations were being adjusted to process liquidation of insolvent financial
institutions.
Until this period, Ministry of Finance had been responsible for financial supervision in
Japan. However, with the growing financial turmoil in the wake of the collapse of
bubble economy, there was much criticism regarding the fact that the Ministry of
Finance held a dual function of financial administration and public financing. There
was also an increasing criticism regarding the discretionary and obscure financial
administration of the Ministry of Finance, which had led to the collapse of bubble
12

economy. Therefore, the financial supervising function was removed from the Ministryof Finance. First, the supervising function was transferred to the Financial Supervisory
Agency. Later, the Financial Services Agency (FSA), which held the authority for overall
financial administration, was founded in July 2000. At that time, the FSA
Commissioner, in the discourse on “The commencement of the Financial Services
Agency,” promised to the Japanese citizens “greater clarification of rules, prompt andstricter implementations of those rules, as well as improvements on the transparency ofthe policy formulation process and administrative procedures.” In other words, theimplementation of a financial administration with high transparency level, based on
clarified rules, was a priority issue.
A turning point from the first stage to the second stage was the Financial
Revitalization Program, launched in October 2002 as a response to an emergency, under
the Minister for Finance Services, Heizo Takenaka. While the financial administration
was severely criticized for its strong intervention in the operations of individual banks,
the Financial Revitalization Program strongly requested major banks to accelerate
their disposal of nonperforming loans (with a balance reduction by half in three years).
The second stage, which began with the introduction of Financial Revitalization
Program, was the period approximately between 2003 and 2007. In May 2003, thefinancial problems of Resona Bank Group surfaced, and based on the discussions heldby the Council Order on Financial Crisis Response, approximately ¥2 trillion of publicfunds were injected.4
Later, with the moderate revival of the economy, completely lifting the freeze on the
payoffs also became a possibility in 2005. Repayments of public funds began as well. It
was a period where the stability of the financial system also began to restore. The
switch from emergency mode to ordinary mode progressed.
Simultaneously, the financial administration’s focus shifted gradually from therevival of a stable financial system, to user or consumer protection. Administrative
measures against banks in this area began to appear frequently.
Detailed analysis conducted by Yamori and Kobayashi(2007). According to the results,
the market recognized that this capital infusion was a “too-big-to-fail” type policy.
413

The third stage was the period from 2007 onward. The December 2007 “Financial
Reform Program – Challenges toward a Financial Services Nation” defined the phasesurrounding the current financial system to be departing from emergency responses
dealing with nonperforming loan problem to a future-oriented phase, aimed at creating
a desirable financial system for the future. If we were to borrow a slogan from the FSA,
the time was entering a phase that saw “qualitative progress in financial regulation(better regulation).” However, in reality, the global financial crises directly triggered thebankruptcy of Lehman Brothers occurred and financial regulations to respond to thecrisis had to be implemented again.

3-2. Current Prudence Policy in Japan
3-2-1. Traditional Preventive Measure
If banks do not fail, the banking industry as a whole will not collapse. In other words,
one measure to prevent the entire banking industry from collapsing is to ensure thateach individual bank does not collapse by protecting banks through limiting competition
between

banks

and

ensuringaminimum

profit.

The

representativecompetition-limiting regulations implemented in post-war Japan were: the virtualprohibition of new entrants; deposit interest rate capping controls; branch regulations(permission was required from the Ministry of Finance for bank branch opening);
business field controls (e.g., separation of banking business and securities business);
short- and long-term business separation controls including specialization of trust
services and financial bond issuance by long-term credit banks only, and domestic andforeign financial market segmentation regulation.
Given the fact that there were hardly any financial institution failures or financial
confusions for a long time after the war, it’s possible to surmise that regulations limiting
competition were successful. However, these regulations became a hotbed for
inefficiency, and the users of financial services experienced various inconvenience.
Furthermore, with the advancements in financial informatization and globalization,competitions with foreign financial markets and financial institutions occurred outside
the regulation framework, thus limiting the effectiveness of competition-limiting
14

regulations (in terms of protecting the profit of the existing financial institutions). In
addition, because financial institutions behave in such a manner as to avoid regulations,
inadequate regulations distort the actions of financial institutions, resulting in an
increase in likelihood of expanding risks.
Astheawareness

of

these

types

of

adverseeffectsincreased,

many

competition-limiting regulations were abolished. For example, in the past, depositinterest-rate ceilings were regulated in accordance with the Temporary Money Rate
Adjustment Act. As a result, all deposit interest rates for all banks had beenstandardized, which led banks not to compete by raising interest rate for procuring
deposits. However, with the liberalization of deposit interest rates, it thenbecame possible for each bank to set its deposit interest rates freely 5.

3-2-2. Current Policy Measures6
We may classify the currently implemented prudence policies into fivedifferent types as follows: 1) Regulations relating to entry and exit, 2)
Regulations concerning banks’ business affairs (products), 3) Regulations inorder to secure the soundness of banking operations, 4) Regulations to protect
the users, 5) Supervision and verification. The details of these are explained
below.

1) Regulations relating to entry and exit
In order for a bank to commence business, a license is necessary. However, the bank
may lose its license in cases where a law was breached. Moreover, a bank cannot
close without permission from authorities.

2) Regulations concerning banks’ business affairs (products)
The scope of a bank’s business affairs is limited by law (which is called Regulations

5

Now, banks are required to set the interest at 0% for current accounts only.

Detailed information on Japanese bank regulation is provided in the FSA website at
http://www.fsa.go.jp/en/policy/ofrsf/index.html
615

Prohibiting Other Business Fields). The objectives of the Regulations Prohibiting Other
Business Fields are as follows: (i) to prevent reciprocal (adverse) interest trade, (ii)
profit through specializing by concentrating on banking business, (iii) preventing therisks associated with the other business spreading to the banks. Similarly, to ensurethat there is no eluding of Regulations Prohibiting Other Business Fields throughthe use of a subsidiary and holding company, there are also limitations on thebusiness affairs of subsidiary companies that banks and bank-holding
companies can have.

3) Regulations in order to secure the soundness of banking operations
In order to ensure the soundness of banking operations, standards related to specificfinancial indicators that must be fulfilled are set. This is called Balance-Sheet
Regulations. Typical examples of existing balance-sheet regulations are regulations
that limit large loans, and the capital adequacy requirements. (Basel Capital Accord).
Regulations limiting large loans stipulate that the amount of a loan to the same
individual must be below an established ratio of capital equity7. These regulations arenecessary because when a loan is given in excess to a specific party, the soundness ofthe bank itself is threatened if the borrower fails to repay the loan. Because the capital
adequacy requirements are especially treated as important they will be examinedfurther in the next section.

4) Regulations to protect the users
In order for users to be able to assess the management contents of banks,
the banks have a legal obligation to disclose their financial statements andother relevant information, even if they do not list their stocks on stock
exchange.

5) Supervision and Verification
In order to be able to check whether the regulations are actually being adhered to,7

Basically, the maximum ratio is 25 percent of bank’s capital.
16

supervision and verification are conducted by financial authorities (such as the FSA andthe Bank of Japan). In addition, appropriate supervision and regulations are necessary
to avoid moral hazard associated with the lender of last resort function, and the deposit
insurance system.

3-3.Capital Adequacy Regulation as a Pillar of Bank Regulation
In 1988, it was agreed in the Bank for International Settlements (BIS) that capital
adequacy requirements unified among the major countries would be implemented.
Following that agreement, the capital adequacy requirements have been enforced inJapan as well. Recently, the capital adequacy ratios have been utilized as standards fora system of prompt corrective action, and been used for depositors to select a securebank. For these reasons, the role of capital adequacy requirements are treated withgreat importance in the banks’ operations and prudence policies.

3-3-1. Old BIS Regulation and New BIS Regulation
Because the current capital adequacy requirements began with the frameworkagreed internationally via the Bank for International Settlements (BIS) in 1988,
they are known as the BIS regulations or Basel Regulation, referring to where BIS
located. In the 1990s, BIS regulations began to form a pillar for bank regulations,introducing early corrective measures that would order business improvements andlimitations on dividends if the capital adequacy ratios were below a predetermined
level.
However, it became clear that there were various problems regarding these BIS
regulations. For example, with regards to the capital adequacy requirements, only
credit risk were being considered, and other risks such as market price risk andbusiness risk, which the financial institutions bear were not considered. As a result,consider long term government securities. As their market price risk is high but thecredit risk is zero, changing the portfolio from short-term government securities tolong-term government securities does not affect capital adequacy ratio. Therefore, the17BIS regulations encouraged banks to hold more long-term bonds. In addition, thehandling of credit risk was also simple, where all enterprises were considered similarly.
This indicated that capital adequacy requirements provided an incentive to lend tohigh-risk enterprises.
With regards to this issue, the new regulations commenced from March 2007 (called
the New BIS Regulations or Basel II). In the new BIS regulations, improvements havebeen made so that not only credit risk but also market price risk and business risk havebeen considered. In addition, improvements have been made for credit risk calculations
so that they reflect the credit worthiness of the borrowers to a certain degree.
In sum, the old BIS regulations started with the objective of urging cautious
management through bank incentives. However, these regulations were insufficient,and thus it became necessary to redesign the regulations.

3-3-2. Overview of Japanese Capital Adequacy Regulation (BASEL II)
The current Japanese capital adequacy requirements were classified into 2 types: one
geared for banks that conduct international business, and the other for banks that
focused only on domestic business. A summary of this is shown in Table 3. In addition,
as shown in Table 4, if the capital adequacy ratio falls below a predetermined level, thenan early corrective measure is initiated by the authorities, in accordance with thedegree of the shortfall in capital.
Furthermore, as mentioned later, given the occurrence of the global financial crisis,
efforts are currently being made to adjust the domestic regulations to Basel III, which
has been agreed upon internationally in 2010.

18

Table 3
Overview of Basel II
Basel I

Basel II

(Source： FSA, The Outline of Draft Rules for the New Capital Adequacy Framework,
March 31 2005. (available at
http://www.fsa.go.jp/news/newsj/16/ginkou/f-20050331-8/14e.pdf).
See also FSA Newsletters, May 2006,

19

Table 4
Overview of Early Corrective Measures
Capital Adequacy Ratio
Banks that
Banks that
Conduct
Focused onlyInternational business Domestic businessMeasures

Less than 8％Less than 4％

Preparation of management improvement programs
And implementation orders

Less than 4％Less than 2％

Prohibiting or limiting dividends and bonus to directors

Less than 2％Less than 1％

Order to enhance capital adequacy, shrink major businessaffairs, conduct merger or abolish bank businesses

Less than 0％Less than 0％

Order to suspend a part of or all businesses

See notes for Table 3.

3-4. FSA’s New Supervisory Stance: Better Regulation
Since the summer of 2007, the FSA has begun implementing further qualitative
improvements in the financial regulations. In other words they are continuing theirefforts for “better regulation.” With regards to better regulation, the following four
points have been considered:

1) An optimum arrangement of rule base supervision and principle base supervision.
2) Prompt early recognition of priority issues and effective responses.
3) Emphasizing the value of financial institutions’ self-reliant efforts and incentives.
4) Improving the transparency and predictability of administrative responses.

1) Rule base and principle baseFirst, we consider “the optimum arrangement of rule base control and principle basecontrol.” Criticisms regarding the financial administration during the previous Ministryof Finance era focus primarily on the issue that there were no clear rules, and it was anarbitrary and discretionary administration. On the basis of that reflection, the financial
control function was removed from the Ministry of Finance, and Financial Supervision
Agency was established, with its basic principle being to conduct a transparent and fair

20

financial administration, based on clear rules.
From that original objective, the FSA’s supervisory technique is a rule-based one,
involving establishing detailed rules, which were applied to individual cases. For thefinancial institution, this was advantages as it ensures predictability and theadministration arbitrariness was removed. However, establishing detailed rules bears
two bipolar harmful effects. Firstly, by determining the rules to a detailed level,
innovative developments in the financial institutions that are being supervised are
constrained. By thinking everything will be fine by following the rules, there areconcerns that financial institutions will then slide into brain-numbed operations.
On the other hand, it cannot prevent the vicious behavior of seeking loopholes in theregulations. There is the trend for regulations to be minutely detailed in order to try tofill loopholes. However, even after doing this, as the rule-making follows on after theoccurrence of problems, it is not possible to say that the protection of the depositors andinvestors is sufficient.
As for the principle base supervision, several main fundamental rules are indicated,
the advantages gained through this framework is that it promotes the financial
institutions adhering to these regulations to have an autonomous approach, and a
degree of freedom in management of the financial institution is ensured, and originality
and ingenuity are encouraged. In addition, based on the principles, the FSA can also
deal appropriately with the kind of behavior seeking loopholes.
While “principle-based” may sound good, it may grant too much discretionary power toan administrative authority because how some ambiguous principle are interpreted is
not sure. It is similar to the opaque discretionary administration from which it wastrying to break away. In addition, in order for the supervision of the principle base towork effectively, the principle is shared by the supervisory authorities and the private
financial institutions. A cultural maturity where “even if it does not violate the law, we
won’t engage in undesirable activity,” becomes a prerequisite.
Considering its original intended form, however, combining the two supervisory
techniques of the rule base and the principle base in a mutually complementary manneris desirable. It is now the case that an optimum combination of both is being sought.
212) Prompt early recognition of priority issues and effective responses
The second pillar of better regulation is the “effective responses towards priority
issues,” which can be referred to as risk-focused, or a forward-looking approach. Thismeans being able to recognize the risks inherent in the financial system as quickly as
possible, and transferring administrative resources effectively, in order to give a
response to such priority issues. In order to do that, an understanding of the economy
and market trends, and an accurate awareness of the strategies and activities offinancial institutions are important, and further strengthening of the communication
between the FSA and financial institutions as well as market participants is essential.

3) Emphasizing the value of financial institutions’ self-reliant efforts and incentives.
There have been proposals for effective and selectable administrative responses, fromvarious perspectives. It is possible to paraphrase this by saying that the aim is toachieve a desirable financial system through the power of the “private,” rather thanbeing led by the “government.”
The trend towards importance being placed on incentives and respecting self-reliant
effort, has to some degree already been interwoven into the framework of recent
financial regulations, such as the Financial Inspection Rating System, Basel II, andother frameworks. Among these, in the Financial Inspection Rating System, there are
ten rating items, including “operational management system; fundamental components,”“legal compliance system,” “management system including customer protection,”“integrated risk control system,” “capital management system,” “credit risk
management system,” “property assessment management system,” “market risk
management system,” “liquidity risk management system,” and “operational risk
management system.” The FSA conducts an evaluation on each item, rating them A, B,
C, or D. The results of the evaluation would reflect the intensity of future inspections(inspection frequency, scope, depth). This system is beneficial for banks because if theresults are positive, then the degree of freedom in business operation increases.
As financial business gets more complicated, it is important to accurately recognize the22limits of what the authorities can do. Therefore, we believe that the most importantconsideration regarding future financial supervisory administration would be whether
private financial institutions that are regulated and supervised are given adequate
freedom to comply with the law.

4) Improving the transparency and predictability of administrative responses.
In the fourth pillar “improving the transparency and predictability of administrative
responses,” FSA’s inspection manuals that stipulate the focus during inspection
supervision, supervision guidelines, inspection principles for each administrative year,
and supervision principles are disclosed. The issue involves aiming for the
improvements of transparency and predictability, such as by disclosing standards foradministrative measures, making improvements in the no-action letter system, andpublishing Q&As on rule interpretation.

4. Banking Regulation Reform under the Post-Bubble Financial Crisis
4-1. Financial Crisis in the 1990s and early 2000s
During the financial crisis in Japan in the late 1990s, many banks and cooperative
financial institutions went bankrupt. Regarding bank failures, 17 banks collapsed,
beginning with the failure of Hyogo Bank in August 1995 and ending with the failure of
Ashikaga Bank in November 2003, as shown in Table 5. The table shows the amount offunds provided by the Deposit Insurance Corporation of Japan (DICJ) to the collapsedbanks. Liquidation costs for the failures of LTCB and NCB were enormous, accounting
for more than ¥3 trillion. In total, ¥17.9 trillion was provided to financial institutions(including credit associations and credit cooperatives) that went insolvent, by the end of
March 2003. Although the deposit insurance premium must cover such costs,
approximately ¥10 trillion government funds (i.e., tax revenues) were used to coverthese costs given the shortage in premium funds. In fact, the Japanese public bore thesubstantial cost of maintaining the reliability of the financial system.
The collapse of the bubble caused by the economic boom from the late 1980s to the23early 1990s triggered instability in Japan’s financial system. The system was stabilized
by fully guaranteeing bank deposits and capital injections from the public fund, as
discussed below.

Table 5Collapsed Banks and Disposition Costs (¥100 million)

8/30/95

Collapsed
institution
Hyogo Bank

Fund by
DICJ
4,730

4/12/99

4/1/96

Taiheiyo Bank

1,170

5/24/99

11/21/96

Hanwa Bank

806

6/14/99

10/14/97

Kyoto Kyoei Bank

438

11/17/97

Hokkaido
Takushoku Bank

11/25/97

Date

Date

Collapsed
institution
Kokumin Bank

Fund by
DICJ
1,837

Kofuku Bank
Tokyo
Sowa
Bank

4,941

8/9/99Namihaya Bank

6,526

17,732

10/4/99

Niigata
Bank

3,817

Tokuyo City Bank

1,238

12/28/01

Ishikawa Bank

1,809

5/15/98

Midori Bank

7,711

3/8/02

Chubu Bank944

10/23/98

LTCB
NipponBank32,35011/29/03

Ashikaga Bank--

12/14/98

Credit

Chuo

7,626

31,414(Source: Data compiled from DICJ at http://www.dic.go.jp/katsudou/katsudou2.html )4-2．Stricter Disclosure Regulations
After the economic bubble burst, the Ministry of Finance (MOF) delayed the processof addressing the problem. Thus, the MOF was criticized for causing an unnecessarily
prolonged financial crisis (Hoggarth et al. (2002), Sakuragawa (2006), etc.)8.
If the problem was cyclical, it would have been solved after the economy had improved,and clearly the MOF should not mechanically handle insolvency cases resulting from a
temporal deficit. On the other hand, if the problem was structural, procrastination
further strains the situation. Unfortunately, the MOF in the 1990s magnified the issue
because they misinterpreted the problem of Japanese banks as cyclical and not
According to Hoggarth et al. (2002), the average duration of a financial crisis in
number of years since 1980 (worldwide) has been 3.6 years; however, it has remained
for nearly 15 years in Japan.
824

structural, and delayed pursuing a solution.
As is often noted, financial institutions with excessive liabilities undertake risky
investments because if these investments prove to be successful, they can offset theirlosses. However, if unsuccessful, they will collapse. Certainly, the high possibility of
failure worsens the degree of excessive liabilities. The longer they delay the closure
decision, the greater the amount of funds needed to protect deposits.
Strong doubt exists as to why the MOF was unable to handle insolvency cases before
experiencing greater losses. A major factor was insufficient information disclosure. First,
the bad loans that each bank was required to disclose solely consisted of the debts offailed firms. Even after the range of disclosure expanded to include the debts of possible
failed firms, the self-assessment of bad loans was so simplistic that other doubtful loans
were assessed as normal.
In addition, a “device” to delay the problem was enforced by both the public and theprivate sectors. For example, when stock prices dropped and the latent profits of equity
capital decreased, the government counted the valuation profit of land that the banks
possessed as equity capital.
However, such a “device” created public distrust over concealing the problem. Because
financial market participants tended to be bearish on uncertainty, the publicconjectured that the banks were concealing more than they really were9. As a result,
this “device” that was designed not to destabilize the market in fact accelerated theunrest. For example, the interest rate premium (Japanese premium) required when
Japanese banks borrow funds from European and American banks, rose suddenly.
This was the time to switch between a traditional supervisory technique that “doesnot see” or “obscures” the problem and a new technique that makes the problem easy toface and grasp10. During this process, the authorities admitted that the use of market
forces by information disclosure was the only choice for them to make.

For example, Nihon Keizai Shinbun (October 12, 2002)stated that a British economic
research firm published an analysis report stating that Japanese financial institutions
must amortize “at least ¥120 trillion” of bad loans, while FSA reported ¥52 trillion (inMarch 2002).
10 Discipline in banking is discussed in Berger (1991) and Spiegel and Yamori (2007).
925

Spiegel and Yamori (2006) examined the situation in detail. In March 1996 and 1997,
credit associations had the freedom to choose to disclose bad loans. Consequently,
certain credit associations did not disclose bad loans, some only disclosed bad loans of
unstable firms, and others disclosed debts including reductions or exemptions ofinterest, as banks do. In March 1998, when compulsory information disclosure wasenforced, almost all credit associations thoroughly disclosed bad loans. Thus, theconcealed amount was also revealed. The study’s empirical results confirmed thatunsound credit associations were passive to disclose; this implies that problematic
information tends to be concealed.
Furthermore, Kondo (2010) also showed that financial institutions with problematic
information tended to be passive regarding disclosure, especially if they were rated byforeign rating agencies.
Theoretically, the possibility exists that banks are willing to disclose under thepressure of competition in the banking market, because depositors do not choose
institutions that are passive on disclosure. However, the effect of competition is reduced
when financial institutions have deposit insurance as their defense. Spiegel and Yamori(2006) and Kondo (2010) indicated that policy makers must set a benchmark for
information disclosure that enables financial institutions to disclose informationcompared with other institutions.

4-3. Safety Net in the Japanese Banking Market and Deposit Insurance
A deposit insurance system plays a central role as a safety net in the modern banking
industry. The system takes on the deposit liability and guarantees payment when banks(including credit associations and credit cooperatives, but excluding branches of foreignbanks in Japan) go bankrupt. In principle, a principal amount of up to ¥10 million(excluding foreign currency deposits and certificates of deposits) and its interest are
guaranteed.
All deposits were protected for their entire amount by March 2002 because thedeposit insurance cap was frozen. In April 2002, savings deposits such as term deposits
were excluded from full protection because of a partial lifting of the freeze on the cap. In
26

April 2005, excluding settlement deposits (checking accounts and new transaction
accounts without interest), all deposits introduced the cap. The savings of Agricultural
Cooperatives (JA) and Fishery Cooperatives have an Agricultural and Fishery
Cooperatives Savings Insurance system, similar to that of deposit insurance.
There are two ways to guarantee deposits. One is the direct payment method, where
the DICJ pays a premium and purchases the deposits of failed financial institutions.
The other is the financial assistance method, in which the DICJ provides financial
assistance to financial institutions that merge with failed financial institutions. The
direct payment method is inconvenient for users because the failed financial institutionceases to exist. For example, depositors that use account transfers for public utility
payments must withdraw their accounts. Thus, the direct payment method has neverbeen used in Japan. In reality, the FSA publicly prefers to solve insolvency cases using
the financial assistance method because the functions of the failed financial institutions
can be taken over.
Besides protecting depositors, the procedure to address systemic risk is also
important in the deposit guarantee system. Because the safety of deposits was always
guaranteed for depositors through the introduction of the deposit guarantee system, it
was unnecessary for them to create a bank run on the basis of uncertain information.
Therefore, banks also did not have to worry about depositors running on a bank andcould thus provide long-term loans.
Although the deposit guarantee system effectively secures the stability of thefinancial system, it has certain limitations. First, it distorts the incentives of both
depositors and bank managers. Depositors could make deposits to banks that offer ahigh deposit interest rate because the deposit is guaranteed even if management
deteriorates. Indeed, a principal amount of up to ¥10 million is guaranteed even if abank fails. On the other hand, bank managers like to engage in risky business because
the premiums are comparatively cheap as long as it is uniform (as it is today). Variable
premium rates, where the deposit premium rises depending on banks’ financial
conditions, have been introduced in the U.S. to prevent adverse effects; however, they
have not yet been introduced in Japan.
27

Second, while depositors do not monitor banks earnestly because they are protectedby the deposit guarantee system, regulators have to fulfill all supervision andmonitoring responsibilities. To minimize adverse effects, an upper bound of deposit
insurance protection (¥10 million) is set. Because large depositors may lose part of theirdeposits, bank management matters to them. Thus, depositors are expected to
discipline bank management.
Third, given the massive relief fund for depositors, the possibility exists that deposit
premiums run short and taxpayer burdens increase. In fact, as many banks had failed
successively since the burst of the economic bubble, it was impossible to cover only by
the deposit premium to fully protect the deposit and therefore approximately ¥10trillion government funds were provided.

4-4. The Lender of Last Resort
The lender of last resort, the Central Bank, lends money to commercial banks when
they are short of liquidity (because funds from private lenders are unavailable as aresult of a run on banks, for example,) and to secure depositors’ trust on financial
institutions and ultimately, the financial system. Indeed, the Bank of Japan providedloans to individual financial institutions (emergency financing) during the financial
turmoil after the burst of the economic bubble.
The emergency lending by the Bank of Japan was considered effective for preventing
a chain of collapses of financial institutions. When exercising the function of the lenderof last resort, the Bank of Japan must judge whether banks are in a temporary liquidity
shortage situation or are insolvent. If the Bank of Japan misjudges, there is a danger ofoverlooking the problem because the Bank of Japan then becomes a lender to bankswith debts exceeding assets. Therefore, the Bank of Japan set four principles of
emergency financing to clarify the rules for invocation (Table 6).

28

Table 6
Four Principles of Emergency Financing by the Bank of Japan
Principle 1. There is a possibility of systemic risk.
Principle 2. It is imperative for the Bank of Japan to finance.
Principle 3. Appropriate response such as clarification of the responsibility of
all concerned must be taken to prevent moral hazard .
Principle 4. Maintaining the financial strength of the Bank of Japan itself
must be considered.

4-5. Public Fund Injections
4-5-1. Positive and Negative Effects
To prevent the crisis, the Japanese government injected funds into banks to reinforce
their equity capital. When equity capital is insufficient as a result of an increase in badloan disposals, banks generally secure their capital from ordinary shareholders.
However, in an emergency situation such as a possible financial crisis, few shareholders
will support banks in increasing their capital. Thus, the possibility exists that the
government injects public funds to maintain stability in the financial system.
The effects of injecting public funds are summarized as follows.

1) Possibility of avoiding bank failure
When banks fail, there are adverse effects not only on depositors but also on firmsthat cannot find other banks for new borrowings. Regardless of their ability to pay
under normal circumstances, the failure of banks facing insufficient liquidity has aharmful effect on the soundness of other banks. Therefore, injecting capital to preventbanks from failing and to stabilize the financial system is a significant social benefit.

2) Effectiveness of the “credit crunch” countermeasure
Banks become able to take risks if their equity capital increases by receiving publicfunds. If bank lending increases, the problem of credit crunch is expected to be resolved.
293) Promotion of the disposal of nonperforming loans
During an economic stagnation, a financial system does not remain stable for long
because banks are unwilling to handle bad loans. The financial recovery of banks
through an injection of capital is expected to promote the disposal of nonperforming
loans.

4) Pump-priming effect of the reorganization of financial institutions
Because there are several banks in Japan, the merger and integration of banks arepromoted through the injection of capital. For example, the Act on Special Measures for
Promotion of Organizational Restructuring of Financial Institutions enacted in
December 2002 actually allowed financial institutions that would do a merger to receive
public funds injections.

However, capital injections have harmful effects. The following issues have beenfrequently pointed out.

1) Moral hazard by banks
If the government always helps banks when they face difficulties, banks may not
make an effort to be safe and may overvalue risky management. Thus, the moral hazardof banks may occur and such risk may increase adversely by injecting capital.

2) Damage to the soundness of the entire financial system
If the cost of the capital injected is imposed on other financial institutions, these
healthy institutions may find themselves in trouble. Therefore, it is not necessary thatthe soundness of the entire financial system will improve from a capital injection.

3) Uncertainty over increases of bank loans
Even if equity capital increases, banks do not automatically increase their lending.
Because it is possible to only increase investments in government bonds, the effects that30

the government anticipates may not necessarily be achieved through capital injection.

4) Concern over extending the existence of problematic banks
The disposal of nonperforming loans should not depend on the financial strength ofbanks. If a bank lacks the ability to dispose of nonperforming loans, public funding will
fail to solve its problem and will only extend its life. It is necessary to strengthen thedisposal functions (e.g., by establishing a Resolution and Collection Corporation and an
Industrial Revitalization Corporation).

5) Decrease in incentives for private financial institutions
Improving sustainable profitability for banks that received public funds may bedifficult if the government's commitment is so strong. In Japan, when the government
planned to inject public funds in response to the financial crisis during the late 1990s,
private banks hesitated to apply for such a capital injection because they feared
increasing government involvement.

4-5-2. Brief Description of Capital Injections
The first injection of public funds into banks in Japan to increase capital occurred in
March 1998 and was based on the Financial Functions Stabilization Act . Total publicfunds of ¥1.8 trillion were injected into 21 banks, including large city banks, to respondto the financial crisis that was aggravated by the failure of banks such as Hokkaido
Takushoku Bank in November 1997. However, because the injection was small, theweak management of banks such as LTCB that received the injection remainedunresolved.
In summer 1998, the world financial crisis that originated in Japan was feared due tothe increase in Japanese premium while international finance crises were expanding.
Thus, the public insisted that a large-scale capital injection was necessary. A total
capital of ¥25 trillion was prepared based on the bank recapitalization bill approved in
October 1998. Beginning with a total injection of ¥7.5 trillion for 15 banks in March
1999, by March 2002, a total of ¥8.6 trillion was injected based on the Law concerning
31

Emergency Measures for Early Strengthening of Financial Functions.
After the bank recapitalization bill lapsed, the Financial Crisis Response ordained in
the Deposit Insurance Law was the only possible scheme for further injection of publicfunds into banks. An amount of ¥2 trillion public funds was injected into Resona Bankin May 2003 based on this scheme. Because the scheme was supposed to be exercised
only in a state of emergency during a financial crisis, it results in responses only after aproblem has occurred.
Therefore, the Financial Function Strengthening Act was approved in 2004, whichenabled the government to inject capital prophylactically into financial institutions thathave not had a problem but that lack capital. Although the Act was originally effective
only until March 2008, a revision in response to the Lehman shock extended its
effectiveness to March 2012.

5. Development of Japanese Banking Regulation after the Lehman Shock
Financial markets throughout the world became dysfunctional after the Lehman
shock. The Japanese financial market was also exposed to a difficult situation, although
not as difficult as in Europe and the U.S. A critical problem was the deterioration in
financing for SMEs, not to stabilize the financial system11. In this section, we discuss
the regulatory measures taken by the government to ensure smooth supply of funds to
SMEs during the period.12

5-1. Revised Act on Special Measures for Strengthening Financial Functions
As discussed in section 3-3, because banks in Japan are bound by capital adequacy
rule, they require additional equity capital to increase lending. Therefore, after the
Lehman shock, the concern was that a credit crunch or credit withdrawal would betriggered regarding SMEs given this capital adequacy rule. Moreover, if many banks
The FSA reported that total amount of subprime-loan-related products that Japanesedepository institutions held as of September 30, 2008, was 797 billion yen, while theTier 1 capital of these institutions amounted to 50.1 trillion yen.
12 A detailed discussion on the system was also found in Yamori and Kondo (2011).
11

32

had weak capital adequacy ratios, the financial system would become unstable.
As discussed in section 4-5-2, the Financial Function Strengthening Act, whichenabled the government to inject public funds for prevention purposes based on
applications from financial institutions, was implemented to strengthen the financial
condition of regional financial institutions in Japan. The Act was temporarily in effectfrom the end of August 2004 to the end of March 2008. Given the seriousness of the
global financial crisis related to the failure of Lehman Brothers, a new Financial
Function Strengthening Act (hereafter, the revised Act) was implemented in December
2008. The revised Act remains in effect until March 2012.
Because the old Act placed significant responsibility on the directors at banks thatreceived public funds, only two banks applied for such assistance, Kiyo Holdings, Inc.
(Kiyo Bank) and Howa Bank. Unlike the old Act, the revised Act does not review
executive responsibilities related to a bank’s poor performance when the bank applies
for a capital injection.
Table 7 lists the banks that received an injection of public funds under the revised Act.
The table indicates that the number of banks that applied for an injection was muchhigher than under the old Act. On the other hand, because management andshareholder responsibilities were not significant under the revised Act, there was aconcern that the problem of moral hazard may occur13.

Based on the Act, Examination Board has been established to review the applicationand monitor the performance of banks. Currently, Yamori, an author of this paper,
serves as a member of this Examination Board.
13

33

Table 7
Banks that Received Capital Injection under the Revised Financial Functions
Strengthening Act
Name of financial institutions

Date of capital injection Amount(¥100 million)

Hokuyo Bank

March 2009

1000

Fukuho Bank

March 200960

Minami Nihon Bank

March 2009

150

Michinoku Bank

September 2009200

Kirayaka Bank

September 2009200

Daisan Bank

September 2009300

September 2009450

Towa Bank

December 2009

350

Kouchi Bank

December 2009150

Fidea Holdings (Hokuto Bank)

March 2010100

Miyazaki Taiyo Bank

March 2010

130

The Shinkumi Federation Bank
(Yamanashi Prefecture Shinkumi)

Note: Capital injection into the Shinkumi Federation Bank was made throughpurchasing trust beneficiary right. Other injections were made by purchasing
preferred shares.
(Source: DICJ Homepage)5-2. New Administrative Measures to Facilitate the Financing of Firms“New measures for financial facilitation” were announced in March 2009 to facilitate
firms’ borrowings because business conditions of not only SMEs but also middle-sizeand large firms deteriorated remarkably during the recession after the Lehman shock.
There are three main measures.
First, special off-site interviews were conducted at the end of FY2008 to investigate
whether banks were eager to supply funds to firms. Based on the results of the34interviews, the operations of major banks as well as regional financial institutions thatwere swamped with complaints were examined from April to June 200914.
Second, the FSA changed the risk weight for emergency guaranteed loans 15 . As
emergency guaranteed loans was fully guaranteed by the public credit guarantee
corporations and banks hold no credit risk about them, the FSA decreased their risk
weight from 10% to an exceptional 0%16.
Third, capital injections based on the revised Act were promoted during open
hearings to financial institutions by requesting them to consider a more positive use of
the Act.

5-3. Act to Facilitate Financing for SMEs
“Act on temporary measures to facilitate finance for SMEs” (hereafter, the Act toFacilitate SMEs Finance) was implemented in December 2009 to assist SMEs that had
difficulty with management and finance, which resulted from the recession after the
Lehman shock. The Act imposes obligations on financial institutions to make efforts to
respond to requests as best as possible when SMEs and mortgage borrowers apply forsoftening borrowing conditions such as extensions of repayment deadlines.
The Act could possibly cause an increase in nonperforming loans; therefore, banks
might hesitate to respond to borrowers’ requests. Thus, some measures were taken to
promote the implementation of the Act. If a financial institution accepts the softening
loan conditions, it does not have to classify them as nonperforming loans in most cases
under the Act. Moreover, although banks must make an effort to respond to borrower
requests, a legal penalty is not specified if they fail to do so. However, banks must

Yearbook “One Year of the Financial Services Agency (Fiscal Year 2008)” indicatesthat there were no regional financial institutions that were swamped with complaints.
15 In the credit guarantee system by then, when loans were defaulted on, financial
institutions bore 20% of the defaulted loans and the Credit Guarantee Corporation bore
80% (a shared responsibility system). The emergency guarantee system that calls for
the Credit Guarantee Corporation to assume 100% of the debt repayment was
implemented in October 2008.
16 In Japan, the public credit guarantee corporations generally guarantee 80 percent ofloans losses. Exceptional emergency guarantee scheme was introduced in October 2008.
Risk weights for loans covered by normal public guarantee scheme remained 10 percent.
14

35

organize their implementation system, report their implementation results to theauthorities and disclose them. A penalty is imposed for false disclosures or reports.
Table 8 summarizes the implementation of the Act from the beginning to the end of
September 2010. The implementation ratio is at a relatively higher level because of themeasures discussed above. However, from the point of view of the financial stability, weare concerned that banks hold many unreported nonperforming loans because
substantial loans with extended repayment periods may be classified as normal loans17.

The Act allows banks to classify these potentially risky loans as normal, but several
banks voluntarily classify them as bad.
17

36

Table 8
Implementation Rate of the Act to Facilitate SME Finance (in cases in which debtors
are SMEs)
1 (%)

2 (%)

Major banks (11)

96.7

85.2

Regional banks (106)

97.1

87.7

Other banks (28)

95.8

86.3

Credit associations (273)

97.7

88.8

Credit cooperatives (160)

97.7

89.9

Labor credit associations (14)

100.0

100.0

98.9

92.0

Agricultural cooperatives and fisheries cooperatives (887)

97.3

87.0

Total (1546)

97.3

87.9

Credit federation of agricultural cooperatives and Credit
federation of fisheries cooperatives (67)

Note 1: Column 1 displays the implementation ratio that equals the implementation
number divided by both the implementation number and the rejection number.
Note 2: Column 2 displays the implementation ratio that equals the implementation
number divided by the total application number. The discrepancy between Column 1
and 2 is due to the numbers of applications under reviews.
Note 3: Saitama Resona Bank is included in the regional banks.
(Source: the FSA)

6. Concluding Remarks
This study explains the current bank regulations in Japan. Although Japan had thesteadiest banking system in the world in the 1980s, the system weakened significantly
after the collapse of the economic bubble in the early 1990s. Indeed, bankruptcies offinancial institutions occurred one after another since 1995. By the early 1990s, the37

administration had successfully arranged mergers of problematic banks with other
healthy banks. However, it had been impossible to prevent these financial bankruptcies
since the mid 1990s because the problems inherent in the financial system exceeded theadministration’s capacity.
First, legal measures to deal with insolvent banks were created. For instance, theDeposit Insurance Law originally did not protect deposits exceeding ¥10 million.
However, the full guarantee of bank deposits was believed to be necessary to prevent a
run on banks by depositors, and thus the law was revised. Moreover, if no bank took
over the assets of failed banks, borrowers of failed banks would experience financial
trouble. Indeed, in the late 1990s, the financial authority could not find a bank willingto take on failed banks. Thus, a special bank was established within the DICJ and alegal system was created to take over the debts of failed banks.
Second, the measures to prevent bank failure must be provided in advance to theadministration. One method is capital injection of public funds, which was establishedin 1998. Another important method is to strengthen information disclosure to ease thelevel of distrust of financial institutions. This stricter disclosure regulation was
implemented in the late 1990s.
Bank supervision regulations have changed in response to the financial crisis inJapan. Because Japanese financial institutions did not hold a large amount of
securitized assets related to subprime loans, direct losses were not large during the
global financial crisis of 2008. Namely, regarding maintaining the stability of thefinancial system, the regulations functioned well.
However, the global financial crisis influenced the future of financial regulations inJapan. Because the U.S. and the European countries have established new rules related
to the international money market, Japan should also review and reform its bankregulations. For instance, capital adequacy regulations are expected to be revised
corresponding to the international mutual agreement of Basel III, which requests anincrease in core capital.
Finally, the regulations and the supervision of banks described in this study were
implemented to increase stability. However, it must be noted that it is necessary to38

activate the economy from the financial side, where economic activity has been sluggish
in recent years18. We leave this matter for future research.

Acknowledgement
This research was partially financially supported by the Japan Society for the Promotion of Science(JSPS), Grant-in-Aid for Scientific Research (A).

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