【No.4】December 2011

The Hidden Risks in Japanʼs FinancialSystemTakeo Hoshi
Professor, University of California, San Diego (School of International Relations and Pacific Studies)
Visiting Researcher, NIRA

The risks in Japan’s financial system
The sovereign debt crisis originating in Greece has spread rapidly to other Europeannations, and is also jeopardizing the soundness of European financial institutions which holdlarge amounts of public debt. In Europe, many banks, including major banks, are experiencing
funding difficulties, and a return of the financial crisis of fall 2008 is feared. In the U.S., manybanks which have not fully extricated themselves from the aftermath of the financial crisis arealso suffering difficulties. In comparison to these problems in European and U.S. financialsystems, the Japanese financial system appears stable. Japanese financial institutions were notmuch exposed to the toxic securitized products that triggered the recent financial crisis, andthe amount of their non-performing loans has not increased. As I will discuss below, however,
the official figures for non-performing loans do not reflect the actual situation, and that large
sums in non-performing loans have come to be hidden since the financial crisis. Moreover, thefact that Japan’s financial institutions hold enormous amounts of Japanese government bonds
implies dangerously high interest rate risk. Japan should come up with effective measures tocontain the credit risk and interest rate risk facing its financial system.

Non-performing loans appear to be declining…
Figure 1 shows the balances of non-performing loans held by large banks (city banks,
former long-term credit banks, and trust banks; 11 banks as of 2011) and regional banks(regional banks and second-tier regional banks; 106 banks as of 2011). Looking at the amountof risk management loans (most popular definition of non-performing loans for Japanesebanks) for large banks (Figure 1A), we see that the amount of non-performing loans quickly
fell after it peaked in March 2002, reflecting the efforts of the banks to reduce thenon-performing loans under the reform program pushed by Heizo Takenaka, who was theMinister of Financial Affairs then. Since March 2006, the amount of non-performing loans

has been below five trillion yen. While the amount of non-performing loans increased slightly
following the so-called Lehman Brothers shock, the amount has been declining since
September 2009.
The regional banks also reduced the amount of non-performing loans after the peak ofMarch 2002, although the pace was slower than was the case for large banks, and the amountfell below 7.5 trillion yen by March 2008 (Figure 1B). In the period ending September 2008,
the amount of risk management loans increased by about 0.4 trillion yen, but immediatelydeclined. We cannot observe adverse effect from the global recession.
Figure 1

Risk management loans (Units: Trillion yen)

A. Balance of risk management loans

B. Balance of risk management loans(City banks, former long-term credit banks, and trust banks)(Source)(Regional banks)

Financial Services Agency, Status of Non-Performing Loans, End-March, 2011,
Table 6 (http://www.fsa.go.jp/en/regulated/npl/20100205.html)

When these figures are considered in isolation, it may appear that Japan’s financial system
has remained sound, being largely unaffected by the global financial crisis and the subsequentrecession. While the amount of non-performing loans held by large banks has increasedslightly, non-performing loans for regional banks have declined against pre-crisis figures. Thisis puzzling because the global recession had a significant effect on the Japanese economy.
How come the amount of non-performing loans held by Japanese financial institutions did
not increase, then? The main reason is the changes in the stance of financial supervision after
the global financial crisis. As the global recession worsened, Japan’s Financial Services
Agency (FSA), in the name of facilitating finance for small and medium-sized enterprises,
encouraged banks to continue providing funding for troubled SMEs. It is not difficult toimagine in the background lobbying by politicians for whom SMEs represent an importantbase of support. In order to ease the provision of bailout funds to SMEs by banks, the FSA
relaxed the supervisory framework several times after the crisis. The changes included
modifications of the method of classifying non-performing loans. With these changes, some2

loans which would previously have been classified as non-performing are now deemedperforming.

Relaxation of supervision to help SMEs
The first major regulatory change came on November 7, 2008, less than two months after
the collapse of Lehman Brothers. The FSA published the Measures to Facilitate the Easing ofLending Terms for Loans to Small- and Medium-Sized Enterprises, which narrowed thedefinition of restructured loans, a category of classified loans1. Previously the FSA’s
Inspection Manual for Deposit-Taking Institutions had stated that a loan with relaxed terms
can still be classified as “normal” if the company has a comprehensive businessreconstruction plan that would make the loan performing in around three years. Now, arguingthat it was in the nature of SMEs that they required more time for business reform, the FSA
allowed the banks to classify a restructured SME loan “normal” if a company has areconstruction plan which would make the loan performing in around five years (includingcases in which the company would proceed in accordance with the plan and the loan become
performing after 5 years but within 10 years). This change made some loans that would havebeen classified as restructured loans previously to be classified as normal. With suchmodification, the reduction of the balance of non-performing loans held by regional banks(which have large SME customer bases) between September 2008 and March 2009 that wesaw above is not puzzling. According to FSA data, of 1.837 trillion yen in loans for which
conditions were relaxed in the first quarter of 2009, 840 billion yen (or approximately 46%)
was not classified as restructured loans because reconstruction plans were formulated during
the quarter2. Given that this figure does not include loans which were reclassified laterbecause the reconstruction plans were formulated well after the terms for the loans wererelaxed (for example in the second quarter of 2009), much more than 50% of restructuredloans must have been reclassified as normal.
The relaxation of financial supervision continued. On December 12, 2008, the Capital
Ratio Regulations were partially revised3. Under the pretext of taking a risk-diversification
effect into consideration, the risk weight for SME loans less than one hundred million yen is75%. Prior to the revision, the one hundred million yen threshold was applied to the total
amount of loans including those with guarantees by a credit guarantee association. The
revision excluded the loans guaranteed by a credit guarantee association in the calculation,
thus increasing the amount of SME loans with the lower risk weight.
On March 27, 2009, the FSA’s Inspection Manual for Deposit-Taking Institutions waspartially revised to encourage even the weakest financial institutions to support troubled3SMEs. The financial institutions that are implementing management reinforcement plans
under the Act on Special Measures for Strengthening Financial Functions are put under
scrutiny of the FSA and they become subject to sanctions if they fail to achieve several
accounting targets specified in the plans. The revision indicated that such sanctions are notautomatically applied for the efficiency ratio, and that considerations should be made for any
efforts the institutions made to facilitate the provision of credit to SMEs4.

Increases in hidden non-performing loans resulting from the Act concerning Temporary
Measures to Facilitate Financing for SMEs
After the Democratic Party of Japan (DPJ) took the power in fall 2009, measures for thefacilitation of financing for SMEs were enshrined in law. The Act concerning Temporary
Measures to Facilitate Financing for Small and Medium-Sized Enterprises (SMEs), which
was enacted on November 30, 2009, stipulated that financial institutions should make efforts
to respond favorably in the event that the recipients of small and medium-sized business loans
or housing loans requested changes to the conditions of those loans. This resulted in a further
change to the FSA’s Inspection Manual to stipulate that, even if a debtor had not yet
formulated a highly feasible and comprehensive business reconstruction plan, if the debtor
was a small or medium-sized enterprise and there was a good prospect that the enterprisewould formulate such a business reconstruction plan within the period of one year from thedate on which the conditions of the loan were changed, the loan would be judged not to beclassified as a restructured loan. In other words, on condition that a company simply claimed
to have a prospect for the formulation of a business reconstruction plan, the company’s loan
could be classified as normal.
The Act concerning Temporary Measures to Facilitate Financing for Small andMedium-Sized Enterprises (SMEs) was initially scheduled to be a temporary measure, ineffect until the end of March 2011, but was later extended until the end of March 2012. From
its enactment to the present, numerous SME business loans and housing loans have been
subject to changes in their terms under the auspices of the Act. Figure 2 shows the status ofchanges in the terms of loans to SMEs up to the end of June 2011, as published by the FSA.
In about one year and a half, SMEs have applied for changes in terms to loans totaling 42
trillion yen, and financial institutions have responded favorably to these requests in the caseof loans totaling 39 trillion yen. Cases in which the applications have been refused represent a
total value of no more than one trillion yen. Excluding cases in which applications have been
withdrawn during the review or prior to a decision, terms have been changed for the loans
representing 97.2% of the total amount.

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Figure 2 Status of changes in loan conditions based on Act concerning Temporary
Measures to Facilitate Financing for Small and Medium-Sized Enterprises (SMEs)(Upper figures: Number of occurrences; Figures within parentheses: Value [Units: Billion yen])
Applications
Ａ
Large banks(11)
Regionalbanks(106)
Other banks(28)
Total(145)(Note)

Approvals
Ｂ

Rejections
Ｃ

Applications
under review

Withdrawals
of applications

Rate ofapproval[B/(B+C)]

284,263(14,567.5)

254,457(13,399.1)

7,653(394.7)

13,681(500.7)8,472(302.9)97.1%(97.1%)

977,128(27,395.3)

884,456(25,283.4)

25,432(646.9)35,162(841.6)32,078(623.0)97.2%(97.5%)

19,075(271.5)

14,917(167.5)

2,082(81.2)

991(12.0)

1,085(10.7)

87.8%(67.4%)

1,280,466(42,264.3)

1,153,830(38,850.0)

35,167(1,122.8)

49,834(1,354.3)

41,635(936.6)

97.0%(97.2%)The records cover the period from the date that the law took effect to the end of June 2011.

(Source) Financial Services Agency, “Chusho kigyo kin’yu enkatsukaho ni motozuku kashitsuke joken no henko-to no jokyo nitsuite” (“Status of Changes to Loan Conditions based on the Act concerning Temporary Measures to Facilitate Financing
for Small and Medium-Sized Enterprises (SMEs)”),(http://www.fsa.go.jp/news/23/ginkou/20110901-1/01.pdf) (Japanese only)

Credit risk for Japanese banks is significantly greater than it appears
It is not clear how much of the loans for which terms have been changed are regarded as
normally performing. However, if we consider that in cases of restructuring of loans carriedout under measures for the facilitation of funding to SMEs prior to the enactment of the Act
concerning Temporary Measures to Facilitate Financing for Small and Medium-Sized
Enterprises (SMEs), around half of the relevant loans were considered normal, and thatconditions for exclusion from the category of restructured loans have since been further
relaxed, with the “prospect” of a business reconstruction plan now sufficient, it is probably
safe to assume that almost all of the loans for which terms have been changed would havebeen classified as non-performing under the previously enforced standards.
If this is the case, then published figures for non-performing loans are around 13 trillion
yen lower than the actual figure in the case of the large banks, and around 25 trillion yen
lower in the case of regional banks. Even if we were to be exceptionally generous and assume
that only half of the value of loans for which terms have been changed under the Act
concerning Temporary Measures to Facilitate Financing for Small and Medium-Sized
Enterprises (SMEs) have been classified as normally performing loans, the reported figures
would still be 6.7 trillion yen too low in the case of the large banks, and 12.7 trillion yen too5

low in the case of regional banks. Since the total amounts of risk management loans as ofMarch 2011 were 4.6 trillion yen for large banks and 6.6 trillion yen for regional banks
respectively, the true figures for non-performing loans are estimated to be at least 11.3 trillion
yen for large banks and at least 19.3 trillion yen for regional banks. For large banks, thisfigure is comparable to the amount of non-performing loans as of September 2004. For
regional banks, the figure exceeds the peak amount recorded as of March 2002. The credit
risk for Japanese banks is clearly higher than it appears.

Interest rate risk of Japanese government bonds holding
In addition to credit risk, Japanese banks are also exposed to interest rate risk arising fromtheir holdings of Japanese government bonds. As is well known, Japanese government debt isenormous, and is increasing. Almost all recent studies conclude that the Japanese fiscal policy
is unsustainable if the current stance continues. For example, a recent paper by the author
with Takero Doi and Tatsuyoshi Okimoto concludes that an immediate increase of tax revenueof around 10% of GDP would be necessary to stabilize Japan’s debt-to-GDP ratio in about 90years. The paper also shows, however, such a drastic tax increase is highly unlikely given theobserved history of fiscal policy in postwar Japan5.
If the market comes to share the wide spread conclusion among researchers that theJapanese fiscal policy is unsustainable, the Japanese government will face difficulty in
refinancing bonds, and the interest rates will go up. More than two thirds of the outstanding
Japanese government bonds are held by Japanese financial institutions. Holdings ofgovernment bonds and regional bonds by Japanese banks amount to 142 trillion yen (as ofMarch 2010). The Bank of Japan’s Financial System Report in March 2010 estimates that ifinterest rates were to increase by 1%, the banking sector would face a capital loss of 4.7
trillion yen. This corresponds to 11.7% of Tier I capital for the accounting year ending inMarch 2010 or approximately double the industry’s pre-tax earnings for the same period.

Rapid normalization of financial supervision and the formulation of a credible plan forfiscal consolidation are necessary
In summary, Japanese financial institutions face great credit risk and interest rate risk.
Failure to respond to this situation would jeopardize a resurgence of the financial crisis, as wehave been observing in Europe. The further injection of capital into financial institutions inorder to enable them to withstand losses, as is being argued for in Europe, is perhaps one

6viable method. The time for such recapitalization is now, before the problems inherent in theJapanese banking system manifest themselves.
Even more important point is the fact that the problems have originated in government
measures. In order to prevent the amount of hidden non-performing loans from increasing
further, it is necessary to stop further extension of the Act concerning Temporary Measures toFacilitate Financing for Small and Medium-Sized Enterprises (SMEs) and to normalize
financial supervision. In addition, the rapid formulation of a credible plan for fiscal
consolidation will be essential to prevent a financial crisis triggered by a sovereign debt crisis.

Notes
1 http://www.fsa.go.jp/news/20/20081107-1.html
2 http://www.fsa.go.jp/news/20/ginkou/20090605-1/01.pdf
3 http://www.fsa.go.jp/news/20/20081224-1.html
4 http://www.fsa.go.jp/news/20/ginkou/20090327-3.html
5 Takeo Hoshi, Takero Doi, and Tatsuyoshi Okimoto (2011).
"Japanese Government Debt and Sustainability of Fiscal Policy," Journal of the Japanese andInternational Economies, forthcoming.

Profile of Takeo Hoshi:
Professor, Pacific Economic Cooperation Chair in International Economic Relations, University ofCalifornia, San Diego, and visiting researcher, NIRA.
His major research area is the study of the financial aspects of the Japanese economy, especially
corporate finance and governance.
Professor Hoshi published the NIRA research report titled Why did Japan Stop Growing? (co-author:
Professor Anil Kashyap, Booth School of Business, University of Chicago) in 2011.
He is the inaugural recipient of the 2006 Enjoji Jiro Memorial Prize, which is given by Nihon Keizai
Shimbun-sha (Japanese equivalent of the Wall Street Journal) to three leading Japanese economists
who work on policy issues every three years.

7What’s NIRA?

The National Institute for Research Advancement (NIRA) is anindependent, private-sector research institute which defines urgent
policy issues and formulates bold and timely policy proposals, seeking tocontribute to the revitalization and further development of Japanesesociety and the Japanese economy.
Utilizing a network of scholars, researchers, and specialists in a wide
range of subjects, NIRA works for the public benefit from a fair andneutral perspective, attempting to reinvigorate policy debate andcontribute to the process of policy formation in Japan. The institutefocuses on domestic social and economic policy, international relations,and regional issues in Japan as its principal areas of research.
Established in 1974 as a government-authorized independent
research institution, NIRA became an incorporated foundation in 2007,and since February 2011 has been recognized as a Public Interest
Incorporated Foundation.

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Tel +81-3-5448-1735

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Copyright Ⓒ 2011 by National Institute for Research Advancement

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