SOFT BUDGET CONSTRAINT PROBLEMSIN THE JAPANESE BANKING SYSTEM *KAORU HOSONO AND MASAYA SAKURAGAWA

ABSTRACTThis paper investigates theoretically and empirically why Japanese banks
continued to extend bad loans during the 1990s. The discretionary enforcement ofminimum capital requirements is found to be the primary reason for this perverse
lending behavior by Japanese banks. Our theoretical analysis shows that when thegovernment imposes high capital adequacy standards but banks can easily
manipulate regulatory capital, poorly capitalized banks tend to roll over bad loans
in order to maintain their regulatory capital ratios. This managerial incentive isstrengthened when banks are allowed to issue subordinate debt as a part ofregulatory capital. Our empirical results are consistent with the hypothesis thatthree tiers of agents – the government, banks, and borrowing firms – faced softbudget constraints. Japanese banks were induced to bail out firms by exploiting thediscretionary enforcement of minimum capital requirements, which eventually
prolonged the non-performing loan problem.

*

We are grateful to Masahiro Hori, Takeo Hoshi, Keiichiro Kobayashi, Kiyoshi
Mitsui, Kazuo Ogawa, Ralph Paprzycki , Yuri Sasaki, Yosuke Takeda, andparticipants of the CIRJE-TCER Macro Conference held in Kyoto for valuablecomments and suggestions.

I. INTRODUCTION
Japan’s non-performing loan problem and the banking crisis by now have lasted
more than a decade.1 Yet, why the bad loan problem has persisted for this longcontinues to puzzle economists and policy-makers, especially since the Japanesebanking system had been believed to be well-functioning before the crisis began.
We attempt to explain the bad loan problem in Japan in terms of the soft budget
constraint problem among three tiers of agents: the government, banks, andborrowing firms. Our hypothesis is motivated by the fact that although the collapseof asset prices in the early 1990s triggered the non-performing loan problem, thecurrent stock of non-performing loans has been newly accumulated after 1993, i.e.
when asset prices had already collapsed.2 Our reasoning is based on the framework
developed by Berglof and Roland [1995] and Aghion et al. [1999], which suggeststhat banks bail out unprofitable firms by extending loans because they expect to bebailed out by the government when they fall into trouble.
In this paper we build a theoretical model that explains a significant part of theJapanese bad loan problem and then provide the empirical evidence that supports
the hypothesis of the soft budget constraint. The notion of the soft budget constraint
was originally formulated by Kornai [1979] to illuminate the economic performanceof socialist economies. Recently, this concept has been applied to phenomena not
only in post-socialist but also in market economies. Even in market economies, it isquite rare for a large bank in severe trouble to go out of business.
Dewatripont and Maskin [1995], Qian and Roland [1998], and others havedeveloped theoretical models explaining the soft budget constraint problem, but few
studies have investigated this hypothesis empirically, probably because it is difficult
to find an appropriate measure of the softness of budget constraints.3 Furthermore,policies leading to softening budget constraints, such as subsidies or government
loans, are much more pervasive in transition economies than in advanced market
economies; thus, if it has proved difficult to find a suitable measure of the softnessof budget constraints in the former, it is even more difficult in the latter.4
Consequently, one of our major tasks in this paper is to find appropriate measures1

of the softness of budget constraints that Japanese banks faced in the 1990s.
Most bank regulations, such as minimum capital adequacy requirements, aredesigned for the purpose of avoiding bank failures, but not necessarily intended todeal with an actually troubled bank. When faced with a banking crisis, regulators
have little guidance on how to restructure or liquidate an insolvent bank and areoften forced to rescue it [e.g., Aghion et al. 1999]. The weakness of capital adequacy
requirements was revealed as soon as Japanese banks experienced capital
shortages as a result of the deterioration in the quality of their assets. The Japanese
government softened banks’ capital constraints by allowing banks to engage indiscretionary accounting and to count subordinate debt issued on non-market terms
as part of regulatory capital.5 Furthermore, the discretionary enforcement of
capital regulation motivated banks to extend loans to unprofitable firms, which
eventually prolonged the non-performing problem. Such behavior is in sharp
contrast with the response of troubled U.S. banks that have tended to shrink theirlending in order to increase their risk-based-capital (RBC) ratio [e.g. Peek andRosengren [1995]].
In the first part, we develop a theoretical model explaining why a bank manager
continues to extend loans to unprofitable firms. We consider the following situation.
First, a bank manager has private information about the quality of the loan
portfolio. Second, shareholders’ control over the manager is so weak that the
manager derives utility not only from the bank’s earnings but also from staying in
his position. Third, the manager is dismissed when the bank cannot meet theminimum capital requirement. Under these assumptions, our theoretical analysis
yields several interesting results. First, when the government sets high capital
adequacy standards but cannot observe the quality of loan portfolios and thus truebank capital, a bank manager has an incentive to inflate the regulatory capital, i.e.,
the numerator of the RBC ratio, by extending loans to unprofitable firms in an
attempt to meet the minimum capital requirement.
Second, recapitalization by subordinate debt does not necessarily diminish the
managerial incentive to bail out unprofitable firms although it always relaxes the2bank’s capital constraint. When the bank can manipulate regulatory capital,
recapitalization by subordinate debt and the rollover of bad loans arecomplementary means for banks to meet the capital requirement.
In the second part we conduct an empirical investigation of the soft budget
constraint hypothesis for three tiers of agents: the government, banks, andborrowing firms. Our sample covers a panel of all Japanese banks that were subject
to the Basel capital standards for the sample period of 1991–1999.

We investigate

empirically whether banks have an incentive to extend loans to unprofitable firms
when the government sets a high capital standard but banks expect to be bailed out
either by recapitalization or by various kinds of accounting manipulation. Bad loans
are classified as the sum of loans to three industries, real estate, construction, andfinance, all of which were seriously hit by the decline in land prices. We regress badloans on the softness of the capital regulation measured by banks’ subordinate debt
or discretionary accounting indexes newly constructed in this paper.
We find evidence that poorly capitalized banks maintained their regulatory
capital by issuing subordinate debt and rolling over bad loans, which supports oursoft budget constraint hypothesis. Underlying this tendency was the government’s“too-big-to-fail” policy, which gave the major banks more leeway to use suchstrategies.” The discretionary enforcement of minimum capital requirements
aggravated the soft budget constraint problem, eventually increasing bad loans.
The present paper is related to a number of theoretical papers that analyze thebad loan problem in the presence of asymmetric information, including Rajan [1994],
Berglof and Roland [1995], Aghion et al. [1999], and Mitchell [2001]. Rajan [1994]
explains the bad loan problem as a consequence of rational behavior on the part ofbank managers who have short-term horizons. Berglof and Roland [1995] point out
that banks may “gamble for bailout” by exploiting government forbearance. Aghion
et al. [1999], and Mitchell [2001] analyze the impact of the government bailout
policies on a bank manager’s incentive to disclose truthfully his non-performing
loans. The present paper incorporates all of these ideas but differs from thesestudies in that it stresses another reason for the bank bailouts. Namely, the soft3

budget constraint problem springs from the minimum capital requirement and therelated forbearance policy on the part of the government.
Recently there is a growing literature that sees the soft budget problem in thebanking system and the misallocation of credit as an important factor underlying
the prolonged stagnation of the Japanese economy. Studies along these lines include
Peek and Rosengren [2003], Kobayashi et al. [2002], Hori and Osano [2002],
Caballero et al. [2003], and Nishimura et al. [2003].
In particular, the present paper is complementary to Caballero et al. [2003] andPeek and Rosengren [2003]. Caballero et al. [2003] attempt to quantify the amountof subsidized lending for the publicly traded firms and find that the level ofsubsidized lending increased markedly during the 1990s, and that the subsidies
were far more common for non-manufacturing firms and for manufacturing firms.
In addition, they argue how unprofitable “zombie” firms that are protected by banks
distort competition throughout the economy. Peek and Rosengren [2003] find that,based on panel data of individual firms and banks, banks with reported capitalratios closer to their required ratios were more likely to make loans to weaker firms.
Our analysis differs from theirs in two respects. First, we develop a theoreticalmodel and analyze the relationship among bad loans, capital ratios, andrecapitalization by subordinate debt of capital-constrained banks. Second, based on
the model we develop we utilize measures of the softness of the budget constraintthat banks face that are broader than the ones used by theirs.
The remainder of this paper is organized as follows. Section 2 sets up the model.
Section 3 conducts the theoretical analysis. Section 4 reports our empirical method
and results. Section 5 concludes.

II. MODEL
We consider a two-period economy with one bank and many potential borrowers.
At date 0, the bank is endowed with capital A and has access to insured deposits
provided at zero interest rate.6 Assume that depositors are repaid at the end of theperiod. The bank is run by a manager and in what follows we use the terms “bank”

4and “manager” interchangeably.
The bank potentially makes two types of loans. One type is a safe loan that needs

I units of funds and returns X with certainty at the end of the period. The netpresent value of the safe loan is positive, such that X > I . The other type is a risky
loan that the bank inherited and initially needed I units of funds. The
continuation of this loan additionally needs I units at date 0, and returns YH withprobability p and YL (< YH ) with probability 1 − p at date 1. When the bank does
not make the additional loan, the investment terminates and the bank receives Z
by liquidating the borrower’s asset through a fire sale. We assume that theliquidation is costly, such that Z < I . The bank then invests another I units offunds in government bonds with zero interest rate. It follows that at date 0 the bankcollects deposits 2 × I − A .
At date 0, the manager privately receives a signal about the return of the riskyloan. Suppose for simplicity that the signal the manager receives is perfectly
correlated with the performance of the risky loan. If the signal is “good”, the final
return is YH with certainty while if the signal is “bad”, the return is YL withcertainty. On the basis of that signal, the manager decides whether to continue or
terminate the risky loan.
We impose several restrictions on the parameters. First, assume that

YL < I + Z < YH . The first inequality says that when the signal is bad, the bank earns
more by terminating the risky loan, while the second inequality says that when thesignal is good, the bank earns more by continuing that loan. Second, assume that( X − I ) + (YL − 2 I ) + A > 0 , which says that, conditional on the signal being bad, thebank’s final equity value is positive even if the risky loan is continued.7 This
assumption is in contrast with the one made by Aghion et al. [1999] and Mitchell[2001], who argue that the manager of an insolvent bank will attempt to hide badloans.
Imperfections in the accounting system are incorporated in our model as follows.
First, the manager is never punished even if he is observed to have chosen a loan
portfolio that turned out to deteriorate the bank’s final earnings. Second, the5manager is never punished even if he is found not to have disclosed latent gains/losses from loans in progress. In other words, the bank is not forced to disclose true
earnings on the basis of market value accounting.
The bank manager not only benefits from holding the stock of the bank but also
enjoys a private benefit as a result of managing the bank. Formally, the manager
maximizes the expected date-1 value of(1)~
U = α × max{E ,− A} + (1 − α ) × B , with 0 < α ≤ 1 ,~where E represents the bank’s final earnings net of the cost of capital, and B

stands for the private benefit that the manager enjoys by retaining his job.8 The
weight α may be related to the manager’s share of the bank’s stock, the degree ofshareholding with affiliated firms, and the government’s forbearance policy. The
second term includes not only the manager’s salary but also non-monetary benefits,
such as perks or the satisfaction derived from controlling the bank. We assume that~the manager receives the private benefit B = B (> 0) when retaining his job until~

date 1 and receives B = 0 when losing his job. This term is meant to capture asituation where the manager is not effectively disciplined to behave in the interestof outside shareholders and may create an incentive for the manager to extend badloans and hence worsen the bank’s profitability. In fact, in Japan, bank managers
are shielded from the influence of outside shareholders through mutualshareholdings with affiliated firms and financial companies.
Finally, we assume a regulatory policy in which the manager is fired and loses
his private benefits at date 0 when the bank cannot meet the minimum capital
adequacy ratio k . Although the decision to fire the manager is formally made by
the board of directors, the government influences the decision indirectly through its
pressure on weak banks．(In this way, the government complements outside
shareholders in exerting the corporate control.

III. THEORETICAL ANALYSIS OF THE BASIC MODEL
In this section we conduct a formal analysis based on the model developed in
Section II. We do this by first establishing a benchmark case and then introducing

6

various aspects of the model.

A. Benchmark without Capital Requirements
As a benchmark, it is useful to examine a world with no capital regulation. The
manager does not worry about losing his job, and so does not have any short-term
concerns. The manager cares only about the bank’s final earnings. When the signal
is good, the manager continues the risky loan, and when the signal is bad, themanager terminates it.

B. Minimum Capital Requirements
Now we analyze the portfolio choice in the presence of capital regulation. The
manager may deviate from the “first-best” choice due to considerations of his own
private benefit. Having received the signal at date 0, the bank has to decide
whether to terminate or continue the risky loan. When the bank follows the“termination strategy”, the bank incurs the loss ( Z − I )(< 0) as a result of theliquidation of the risky investment. The other I units are then invested ingovernment bonds. Since the bank writes off loan losses, it follows that at date 0 thebank reports the risk-based-capital (RBC) ratio as { A + ( Z − I )} I , where thenumerator represents the sum of the initial capital and the disclosed loan losses
and the denominator states that (only I units of loans will be made. On the other
hand, when the bank follows the “continuation strategy”, it is normally obliged tomake provisions against possible loan losses, and hence in the face of a bad signal,
the bank has to report at least some of (YL − 2 I ) as loan-loss provisions. In fact, if
the continued loan is discovered to be a bad loan, the government may force thebank to promptly write off that loan. However, since the quality of the continuingloan is the bank’s private information, the manager attempts to behave as if hereceived a good signal. Additionally, the practice of historical cost accounting helps
the bank to hide the bad loan. When continuing the risky loan, the bank reports the
RBC ratio as A 2 I , which is greater than the ratio of the termination strategy( A + Z − I ) / I if

2( I − Z ) > A is met. This inequality is more likely to hold if the7bank’s capital is small or the liquidation of the bad loan is costly. We assume that
this inequality holds throughout this paper. It follows that the manager is given theoption of overstating the RBC ratio by extending the bad loan.
Outsiders attempt to gauge from the disclosed RBC ratio what strategy thebank takes. However, when the disclosed RBC ratio is A 2 I , outsiders cannot
discern whether the quality of the continued loan is good or bad.
It matters whether the reported RBC ratio exceeds the minimum capital
adequacy ratio k or not. If { A + ( Z − I )} I ≥ k , the bank can meet the minimum
capital requirement either by continuing or terminating the risky loan. However, if{ A + ( Z − I )} I < k , the manager cannot meet it by terminating the risky loan. If thesignal is bad, although outside shareholders want the manager to terminate therisky loan, the manager may prefer to continue it due to the private benefits heenjoys.
Since our goal is to analyze the mechanism underlying the continuation of badloans, in what follows we concentrate on the conditions under which the bankcontinues the risky loan conditional on the signal being bad. We expect that the
manager will behave differently, depending on the severity with which capital
regulations are enforced. We continue the analysis by distinguishing banks in termsof their initial capital level. First of all, we examine the behavior of awell-capitalized bank that can meet the minimum capital requirement either bycontinuing or terminating the risky loan, so that min[{ A + ( Z − I )} I , A 2 I ] ≥ k .
This inequality is more likely to be met when the initial level of bank capital A isrelatively high. The capital regulation does not distort the portfolio choice. The
manager cares only about the bank’s final earnings in deciding whether or not tocontinue the risky loan. In the face of a good signal, the manager continues therisky loan, while in the face of a bad signal, the manager terminates it.

Proposition 0: If the signal is bad, the manager of the well capitalized bankterminates the risky loan.

8Next we examine the behavior of a bank that is still fairly well-capitalized but canmeet the capital requirement only by continuing the risky loan, so that

{ A + ( Z − I )} I < k < A 2 I . This inequality is more likely to be met when the initiallevel of bank capital A is relatively low. When the signal is bad, the manager may
face the choice of whether to consider the bank’s equity value or his private benefit
in his decision. Conditional on the signal being bad, the manager obtains

α ( X + Z − 2 I ) under the termination strategy, and α ( X + YL − 3I ) + (1 − α ) B under
the continuation strategy If the manager writes off the loss by terminating the loan
and the RBC ratio falls below the threshold level of k percent, he will be fired andlose his private benefits. We obtain the following.

Proposition 1: Having received the bad signal, the manager of the fairly
well-capitalized bank continues the risky loan if the following inequality is met:(2)

(1 − α ) B > α ( Z + I − YL ) .

The L.H.S. of inequality (2) represents the manager’s private benefit of meeting thecapital requirement, and the R.H.S. represents the cost of continuing the bad loan.
For some range of parameters, the manager chooses to continue the risky loan
although outside shareholders would want the manager to terminate it. The
regulatory policy induces the manager to extend loans to unprofitable firms, whichthen leads to a deterioration of the bank’s loan portfolio. If the government
alternatively were to take a “loose” regulatory approach
under which the manager could keep his position even after the bank had violated
the BIS constraint, the manager would choose to terminate the risky loan.9
Proposition 1 is closely related to the fact that it is difficult to evaluate bankcapital. In terms of the model, since the loan quality is the bank’s private
information, the bank can manipulate the numerator of the RBC ratio by
continuing the risky loan. What is more, it is important to note the impact of thegovernment’s policy with regard to allowing or not allowing banks to engage indiscretionary accounting has. A forbearance policy on the part of the government

9

will soften the bank’s budget constraint, which in turn will soften the borrowing
firm’s budget constraint and ultimately result in a non-performing loan. Very often
the government does not force banks to use current market accounting. The
government’s lax enforcement of banking regulations allowed banks to hide latent
losses and induced them to bail out struggling borrowers.
Finally we examine the behavior of a poorly capitalized bank that can meet thecapital requirement neither by continuing nor terminating the risky loan, so thatmax[{A + ( Z − I )} I , A 2 I }] < k . This inequality is most likely to apply when theinitial level of bank capital A is very low.
If the signal is bad, the manager would obtain α ( X + Z − 2 I ) under thetermination strategy and α ( X + YL − 3I ) under the continuation strategy. Since thebank cannot meet the requirement either by continuing or terminating the risky
loan, the manager has no incentive to roll over the bad loan.

Proposition 2: Having received the bad signal, , the manager of the poorly
capitalized bank terminates the risky loan.

Propositions 0, 1, and 2 jointly imply a nonlinear relationship between the portfolio
choice and levels of bank capital. At low or high levels of bank capital, the bank’s
profitability is more important to the manager than his private benefit. Only forintermediate levels, the bank manager places more weight on his private benefit
than on the bank’s profitability.
We now make a few comments on the government’s behavior of allowing banks
to engage in discretionary accounting. One story is that the government cannot
observe banks’ loan portfolios and thus is forced to allow banks to engage indiscretionary accounting. Another is that the government also prefers thecontinuation of bad loans because it cares not only about the bank’s profit but alsocares about depositors and borrowers that would suffer in the case of bankinsolvency. Given such consideration, the situation can be characterized as one ofsoft budget constraint problems relating to three tiers of agents – the government,

10

banks, and borrowing firms – where banks are induced to bail out firms because
they can exploit the government’s softness.

C. Recapitalization by Subordinate Debt
We have thus far assumed that our bank can raise funds only by collecting
deposits. Here we extend the basic model to allow the bank to issue subordinate
debt as another means of raising funds. Subordinate debt is, in case of bankinsolvency, senior to equity but junior to any other debt including insured deposits,
and admitted as a component of tier 2 capital under the special rule of the Basel
Accord. Moreover, subordinate debt is, in principle, expected to play a disciplinaryrole on banks and thus limit banks’ incentive to take on risk [e.g. Calomiris [1999]].
Banks that take on excessive risk will find it difficult to sell their subordinate debt,
and will be forced to shrink their lending to satisfy capital adequacy requirements.
The situation in Japan deserves some comments. In the 1990s, Japanese banks
used subordinate debt to restore capital bases undermined by asset pricedeprecation and non-performing loans (Horiuchi and Shimizu [1998] and Ito andSasaki [2002]). However, for a number of reasons, subordinate debt was not fairly
priced to reflect banks’ default risk. For example, subordinate debt was neverpublicly traded and instead was purchased by associated life insurance companies
and the government. What is more, the government often repaid creditors on behalfof insolvent banks.10
Suppose that at date 0, having received the signal, the bank decides whether toissue subordinate debt to outside investors at date 0. Let the date 0 price ofsubordinate debt be denoted by D0 ; the bank raises the fund D0 by issuing
subordinate debt and promises to repay D at date 1. Suppose that D0 is given
exogenously. This assumption is justified by the fact that tier 2 capital should beless than tier 1 capital. Suppose also that the government repays the subordinate
debt on behalf of the bank when the bank is insolvent although this assumption
might destroy the primary role of subordinate debt. Assume finally that the bankinvests the raised cash in government bonds.

11

Since the government guarantees repayment, it is easy to see that D0 = D .11
The subordinate debt does not influence the bank’s final earnings and works only asa buffer to relax the original minimum capital requirement. The bank can raise the
RBC ratio up to { A + ( Z − I )} I under the termination strategy, and up to( A + D) 2 I under the continuation strategy.
Let us now consider the role of subordinate debt in the strategy of a fairly
well-capitalized bank. The manager of the fairly well-capitalized bank determines
the portfolio according to whether { A + ( Z − I ) + D} I exceeds the threshold ratioof k . If { A + ( Z − I ) + D} I < k , the manager does not have any incentive to issue
subordinate debt. (As Proposition 1 suggests, the manager will roll over a bad loan
to unprofitable firms. If, conversely, the subordinate debt D is large enough tomeet { A + ( Z − I ) + D} I ≥ k , the manager may have an incentive to issue
subordinate debt because this may provide the bank with the opportunity to meetthe minimum capital requirement. In the face of a bad signal, the manager would
obviously prefer to terminate the loan.

Proposition 3: Suppose that { A + ( Z − I ) + D} I ≥ k holds. Having received a badsignal, the manager of the fairly well-capitalized bank issues subordinate debt andterminates the risky loan.

Comparing Propositions 1 and 3 reveals that the fairly well-capitalized bank, whenallowed to issue subordinate debt, is more likely to refrain from continuing the badloan. The option to issue subordinate debt diminishes the managerial incentive tocontinue the bad loan and rectifies the perverse effect of capital requirements on theloan portfolio.
We next turn to the case of the poorly capitalized bank. Proposition 2 shows thatthe manager of a poorly capitalized bank never rolls over a bad loan when the funds
that the bank can raise are limited to deposits. However, if the bank can also raise
funds by issuing subordinate debt and the amount thus raised is large enough tosatisfy max[{ A + ( Z − I ) + D} I , ( A + D ) 2 I ] > k , the poorly capitalized bank may

12

have an incentive to issue subordinate debt. Since it is tedious to analyze all
possible cases, we focus on the interesting case when the bank can meet theminimum capital requirement only by a combination of issuing subordinate debt
and continuing the risky loan, such that { A + ( Z − I ) + D} I < k ≤ ( A + D) 2 I .
When the signal is bad, the manager would obtain α ( X + Z − 2 I ) under thetermination strategy and α (2 X + YL − 4 I ) + (1 − α ) B under the continuation
strategy. We obtain the following:

Proposition 4: Suppose that { A + ( Z − I ) + D} I < k ≤ ( A + D ) 2 I . Having received
the bad signal, the manager of the poorly capitalized bank issues subordinate debt
and continues the risky loan if inequality (2) holds.

Note that if inequality (2) holds, the poorly capitalized bank will also issue
subordinate debt and continue the risky loan when it receives a good signal.
Comparing Propositions 2 and 4 reveals that the poorly capitalized bank is more
likely to extend the bad loan when it is allowed to issue subordinate debt.
Recapitalization by subordinate debt, together with the continuation of the bad loan,
provides the manager with room to meet the capital requirement, strengthening themanagerial incentive to continue the bad loan.
The effect of recapitalization on the managerial incentive for moral hazard ismixed, depending on the initial level of the bank’s capital relative to the thresholdratio. The recapitalization diminishes the managerial incentive to extend bad loans
for the fairly well-capitalized bank, but strengthens it for the poorly capitalizedbank. When banks are allowed to recapitalize by subordinate debt, banks that are
initially better capitalized tend to terminate bad loans, whereas less wellcapitalized banks tend to continue them.
We briefly discuss the case when the bank becomes insolvent when the risky
loan fails, that is, ( X − I ) + (YL − 2 I ) + A < 0 . The analysis is a little complicatedbecause the effect of the managerial incentive interacts with the equityholders’risk-shifting. Consider the same case as that analyzed in Proposition 4, such that13

{ A + ( Z − I ) + D} I < k ≤ ( A + D) 2 I . When the signal is bad, the manager of thepoorly capitalized bank receives, as before, α ( X + Z − 2 I ) under the termination
strategy but (1 − α ) B − αA under the continuation strategy due to the limited
liability constraint. The manager of the poorly capitalized bank issues thesubordinate debt and continues the risky loan if (1 − α ) B > α ( X + Z − 2 I + A) . Solong as the subordinate debt is government-guaranteed, the managerial incentive toroll over the bad loan can be preserved.
The perverse impacts of subordinate debt could be eliminated if the price ofsubordinate debt reflects the bank’s credit risk. Lift the assumption of thegovernment guarantee. Furthermore, assume that some information regarding thesignal the bank receives is revealed to outsiders. Given these modifications, theprice of subordinate debt would reflect the credit risk, and subordinate debt would
play a role in disciplining banks that otherwise would roll over bad loans.

D. Empirical Implications
The discussion in this section so far implies the following relationship between
the RBC ratio and bad loans as a proportion of total loans :
(3)

RBC =

A + (1 − d )( Z − I ) + D,(1 + d ) I

where d is an indicator, taking on zero when the risky loan is liquidated, and one
when continued. The RBC ratio depends on the initial true capital A , whether thebad loan is extended, and whether subordinate debt is issued. Which component of
the capital base contributes to raising the RBC ratio significantly affects thecorrelation between the RBC ratio and the bad loan ratio. If a high RBC ratio isassociated with high initial true capital or high earnings, the manager is more
likely to liquidate the bad loan; a high RBC ratio tends to be associated with a low
bad loan ratio. On the other hand, if a high RBC ratio is associated with low initialtrue capital, the manager is likely to continue bad loans and to issue subordinate
debt; a high RBC ratio tends to be associated with a high bad loan ratio (whenA 2 < I − Z ) (Propositions 1 and 4).
14Additionally, we have the following relationship between subordinate debt andthe bad loan ratio. If recapitalization by subordinate debt works to weaken the
incentive for banks to roll over bad loans, as is the case for fairly well-capitalizedbanks, a high ratio of subordinate debt will be associated with a high bad loan ratio(Proposition 3). If, conversely, recapitalization works to promote the rolling over ofbad loans, as is the case for poorly capitalized banks, a high ratio of subordinate
debt will be associated with a high bad loan ratio (Proposition 4).
The model thus allows us to posit the following hypotheses concerning poorly
capitalized banks which will be examined empirically further below. The first
hypothesis is that the correlation between the bad loan ratio and the RBC ratio is
positive, reflecting poorly-capitalized banks’ incentive to roll over bad loans. The
second is that the correlation between the bad loan ratio and the true capital ratioor earnings is negative, because banks with a really low level of true capital orearnings cannot meet the minimum capital requirement in any way. The third
hypothesis is that the correlation between the bad loan ratio and subordinate debt
is positive because subordinate debt strengthens poorly capitalized banks’ incentive
to roll over bad loans.

IV. Empirical Analysis
A. Basel Capital Standards and the Manipulation of Regulatory CapitalIn this subsection, we briefly explain how the regulatory authorities assisted
Japanese banks in manipulating regulatory capital while implementing the Baselcapital standards. The RBC ratio is defined as the capital base divided byrisk-adjusted bank assets. The capital base consists of tier 1 “core” capital and tier 2“supplementary” capital. Tier 1 capital comprises mainly stock issues and disclosed
reserves, including share premiums and retained earnings, while tier 2 capitalcomprises undisclosed reserves, including unrealized capital gains on securities,
provisions for general loan losses, and subordinate debt with maturities exceeding
five years. Tier 2 capital cannot exceed the amount of tier 1 capital as a contribution15

to total capital.
Though both tier 1 and tier 2 capital are subordinate to deposits, tier 1 capital ismore “explicit” and “permanent” than tier 2 capital (e.g., Dewatripont and Tirole,[1994]), and is defined in a consistent manner for all countries. In contrast, tier 2
capital, the definition of which depends on national discretion, is easier tomanipulate than tier 1 capital.
When the stock market bubble collapsed but stock prices were still relatively
high at the beginning of the 1990s, Japanese banks were permitted to countunrealized capital gains on securities as tier 2 capital.12 Banks were also allowed tocount subordinate debt as tier 2 capital even though this was held bykeiretsu-affiliated life insurance companies who also issued subordinate debt tothese banks. Such mutual holding of subordinate debt has increased further since1996 when the regulatory authorities imposed risk-based capital adequacy
requirements, the so-called “solvency margin” standards, on life insurancecompanies. Afterward, when the stock market declined further and many banks’unrealized capital gains melted away, the regulatory standards concerning capitalgains on securities changed. Banks were allowed to count stocks at acquisition costand ignore any unrealized capital losses. On the other hand, banks were allowed tocount unrealized capital gains on land assets as capital base. Banks were able toinflate their capital base because a large proportion of the land they held had beenacquired long before the price hike in the late 1980s. Additionally, the value ofdeferred taxes was also permitted to count as tier 1 capital.
As a result of these accounting manipulations, regulatory capital considerably
diverged from true or economic capital. Figure I reports the RBC ratio for the majorbanks as of March 1997. Hokkaido Takushoku Bank and Long-Term Credit Bank ofJapan recorded RBC ratios above 8 percent although both of them eventually failed
within two years of March 1997. Only Nippon Credit Bank, which failed in 1998,
recorded a ratio short of 8 percent.
As one measure of true capital, we use the market-valued capital measured
by the number of stocks multiplied by end-of-fiscal-year stock prices. Figure I also

16

reports the market capital ratio, defined as the market-valued capital divided by
the sum of the market-valued capital and total debt. Most of the major banks
displayed lower market capital ratios than RBC ratios. Notably, the market-valued
capital ratios of the three failed banks displayed even lower values than those of theother, surviving banks. Thus, the stock market valuations reflected the risk offailure of these three banks even though they had disguised the true level of theirregulatory capital.
Let us now look at the components of the capital base in detail. Figure II reports
the tier 1 capital and the major components of tier 2 capital as a proportion ofrisk-adjusted assets for the major banks as of March 1997. Almost all the majorbanks reported tier 1 capital ratios above 4 percent. Among the components of tier 2
capital, subordinate debt accounted for a dominant portion among many banks,
especially at Hokkaido Takushoku Bank and Long-Term Credit Bank of Japan, twoof the three failed banks. This observation suggests that banks did not issue
subordinate debt at market conditions but were able sell it to affiliated life insurers(e.g., Horiuchi and Shimizu [1998]; Ito and Sasaki [2002]).

B. Overview of Bank Portfolios in the 1990s
Before formally analyzing the impact of the discretionary implementation ofcapital regulations on bank portfolios, we briefly review the trend of Japanese banks’
portfolios in the 1990s.

Even though they were burdened with huge amounts of nonperforming loans,
Japanese banks did not shrink loans outstanding until 1998. Figure III presents
Japanese banks’ outstanding corporate loans by industry. While Japanese banks
decreased their lending to manufacturing industries, the most profitable sector,
they increased their lending to the real estate and the construction sector, whichwere suffering from the persistent decline in land prices 13 14.
To examine the financial health of these industries, we estimatehow many years
it would take borrowing companies to repay their debts by calculating the sum of
total borrowing and corporate bonds outstanding divided by operating profits.

17

Comparing the average estimated years of debt repayment in the 1990s with theaverage values of the 1980s, we find that they increased sharply from 15 to 36 years
for the real estate sector and from 8 to 14 years for the construction sector, while
they rose moderately from 6 to 9 years for the manufacturing sector.15 The shift inbank loan portfolios is inconsistent with what one would expect to happen if banks
were profit-motivated, suggesting that Japanese banks continued to extended loans
to unprofitable industries even though it was unlikely that those loans would berecovered.16
This tendency was especially pronounced among those major banks that later
failed, i.e., Hokkaido Takushoku Bank, Long-Term Credit Bank of Japan, andNippon Credit Bank. Figure IV reports the sum of loans to the real estate, theconstruction, and the finance sector as a proportion of total loans – summarilyreferred to as “real estate-related bad loans” or simply “bad loans” hereafter – forthese failed banks as well as the surviving major banks. Long-Term Credit Bank ofJapan and Nippon Credit Bank both sharply increased their share of bad loans justbefore their failure.

C. Hypotheses and Estimation Method
We empirically investigate the hypothesis of the soft budget constraint among
three tiers of agents, the government, banks, and borrowing firms, by analyzing
how discretionary accounting of regulatory capital affected banks’ loan portfolios.
While it is difficult to directly observe the rolling over of bad loans from theavailable data, the hypotheses we presented in section III. D should enable us totest the relationships between bad loan ratios on one hand and RBC ratios and theircomponents on the other.
Given that land prices declined and the quality of loans deteriorated during the
1990s, we may safely assume that Japanese banks received bad signals from theirborrowers. Furthermore, we may also assume that Japanese banks most closely
resembled the case of the “poorly capitalized bank” in the discussion above. If these
two assumptions hold, then Proposition 4 applies to Japanese banks and the share18

of bad loans should be positively related to the RBC ratio and the ratio ofsubordinate debt in risk-adjusted assets, while it should be negatively related to themarket-valued capital ratio and the rate of return on bank assets.
To test these hypotheses, we estimate the following equation:(4)

Bad Loan Share i ,t = β 0 + β 1 RBC i ,t −1 + β 2 MVC i ,t −1 + β 3 ROAi ,t −1
1999+ β 4 PLAND i ,t −1 + β 5 X i ,t −1 + f + ∑ δ s Year ( s ) t + ε i ,t
i s =1992

The dependent variable is bad loans as a proportion of total loans. RBC is therisk-based capital ratio as defined by the Basel standards, MVC stands for themarket-valued capital ratio, ROA represents the operating profit as a proportionof total assets, and PLAND is the rate of change in land prices. X is a vector of
additional characteristics that may affect banks’ loan portfolios. Examples ofadditional characteristics that we include are bank size and share ownership. When
we examine the effect of subordinate debt, we decompose the RBC ratio into theshares of tier 1 capital and the major components of tier 2 capital. We use loans to
the real estate, the construction, and the finance sector as a measure of bad loans.
Our reasons are as follows. First, real estate loans are inherently risky because realestate prices tend to move in the same direction and it is therefore difficult forbanks to diversify away the credit risk associated with changes in real estate prices.
Second, the profitability of real estate loans declined after the collapse of the asset
bubble in the early 1990s. Third, as recent bank disclosure reports have shown,these three sectors accounted for a major fraction of disclosed non-performing
loans.17 Finally, we include financial companies because Japanese banks often usedtheir financial subsidiaries as dummy companies to lend to real estate companies.
The rate of change in land prices, denoted by PLAND is used to capture theprofitability of bad loans. The profitability of real estate-related bad loans is moresensitive to the change in land prices than other loans because these industries use
land more intensively than others. Profit-motivated bank managers are supposed tocontract lending to these three industries as land prices decline, but if managers
deviate from profit-maximization and pursue their own private goal, the share of19bad loans will be uncorrelated or even negatively correlated with land prices. Land
prices also influence borrowing firms’ collateral values and thus banks’ profits sincea large fraction of bank loans is collateralized with land.
As for bank governance, we use two kinds of variables. One is the proportion ofmanagerial ownership, denoted by MANAGER . A bank manager who holds a
sufficient proportion of shares of his bank tends to be profit-motivated, refraining
from extending bad loans to poorly performing firms. The share of bad loans may becorrelated negatively with the manager’s share ownership. However, if the manager
holds a sufficiently large proportion of shares beyond some threshold, he may
entrench himself to avoid large shareholders’ intervention [e.g., Gorton and Rosen[1995]]. To take into account a possible nonlinear effect of share ownership on banklending, we include also its squared value as an explanatory variable.
The second ownership variable we consider is the number of shares held byfinancial institutions as a proportion of the total number of shares issued, denotedby KEIRETSU . The larger the proportion of a bank’s shares held by financial
institutions, the stronger is the latter’s incentive, as block shareholders, to inducebanks to pursue profits. On the other hand, if banks and other financial institutions
cross-hold shares within the same keiretsu, the proportion of bank stocks held byfinancial institutions may represent a proxy for the closeness of the keiretsu
affiliation.18 If this is the case, managers of banks and other financial institutions
can potentially entrench themselves and pursue their private goals. To take into
account these conflicting effects of the share of financial institutions’ ownership, we
include KEIRETSU and its squared values as explanatory variables.
The size of a bank, which we measure by the logarithm of bank assets( ASSET ), may affect the share of bad loans via several routes. Large banks candiversify their loan portfolios and avoid the concentration of loans to particularindustries, which may decrease the share of real estate-related bad loans. On theother hand, anticipating the government’s “too-big-to-fail” policy, large banks are
more inclined to extend risky real estate-related loans and/or to roll over bad loans.
Therefore, the share of real estate-related loans may be correlated either negatively

20

or positively with bank size.
To control for other bank characteristics, we estimate a fixed bank effect modelby including a bank dummy, f i .19 Macroeconomic variables that may affect abank’s loan portfolio are all captured by a year dummy, Year . Note that all the
explanatory variables except for the dummies are one-year lagged values to avoid
any possible endogeneity problem.

D. Data
Our main source for banks’ balance sheet data is the Nikkei Financial

Statement Data of Banks (CD-ROM version, 2000). This data set covers all
Japanese banks, including city banks, long-term credit banks, trust banks, andregional banks. Our sample consists of those banks that were subject to the Baselcapital standards. Banks are divided into major banks (city banks, long-term credit
banks and trust banks) which operate nation-wide and regional banks which
operate in and around the prefecture where their head office is located.
The sample period is from March 1991 to March 1999, i.e. the period following
the collapse of the bubble in land prices. When two or more banks are involved in amerger or acquisition, we exclude these banks for that year and the following year
from our sample because of the lag structure in the estimated equation.
Data on the RBC ratio and its components are collected from each bank’s
financial statements. For stock price data, we use the Kabuka [Stock Price]
CD-ROM, 2002, and (Kabuka Soran [List of Stock Prices], both published by Toyo
Keizai Shimposha. For land prices, we use the posted price index for land forcommercial use for the prefecture where a bank’s head-office is located. This land
price index is published by the Ministry of Land, Infrastructure and Transport.
Table I reports descriptive statistics of bank characteristics. The figures for(ASSET) in the first row imply that, on average, the assets of the major banks wereabout ten times as large as those of the regional banks. The RBC ratio was almost
the same for major and regional banks. The although the required capital ratio was
8 % (international standard) for major banks and 4% (domestic standard) for many21

regional banks. This suggests that major banks were more severely constrained bycapital requirements. bad loan share was higher for major banks than for regionalbanks. Importantly, the capital composition was different. Tier 1 capital made up asmaller proportion of the regulatory capital for major banks than for regionalbanks; consequently, major banks relied more on tier 2 capital, particularly
subordinate debt, than the regional banks did. Greater subordinate debt accounts
for most of the larger share of tier 2 capital held by the major banks. Furthermore,
the lower part of Table I shows that the correlation between the market-valued
capital ratio and the RBC ratio is negative for major banks but positive for regionalbanks.
These statistics suggest that Japan’s regulatory authorities have exercised
greater forbearance toward the major banks than the regional banks by allowing
the former to recapitalize using subordinate debt. Therefore, we estimate thelending behavior of the major banks separately from that of the regional banks.

(Table I should be placed around here.)

E. Determinants of bad loans
We now turn to the results of our estimation. Table II presents the estimation
results for the major banks. In all the tables depicted hereafter, White’sheteroskedasticity-consistent standard errors are reported in parentheses. In
addition, symbols, “**” and “*” show the significance at 5 percent and 10 percent,respectively.

Column 1 shows the results of the basic estimation that includes only

the fundamental variables, such as ROA , PLAND , and ASSET .

(Table II should be placed around here.)

The coefficients on ROA and PLAND are both significant and negative. This22

result suggests that banks’ behavior was not governed by the profit motive.
According to standard banking theory, in a frictionless world, banks should be
striving to decrease the share of bad loans if they have a low ROA and/or land prices
fall. The negative coefficients on ROA and PLAND support the hypothesis thatmanagers of Japanese behaved or were forced to behave in way that diverged fromthe principle of profit maximization.
Column 2 shows the estimation result when we add the RBC ratio. The
coefficient on RBC is significant and positive. A high RBC ratio was associatedwith a high bad loan ratio. This finding suggests that, as stated in Section 3.D,banks with low true capital extended bad loans in order to dress up their balance
sheet. Column 3 shows the estimates when we further add the market-valued
capital ratio. The coefficient on MVC is significant and negative, while thecoefficient on RBC remains significant and positive. The opposing signs of the twocapital ratio coefficients suggest that banks attempted to exploit the difference
between true capital and regulatory capital. To check this, we add the difference ofthe two capital ratios (denoted by ACCOUNT ) as an explanatory variable (column
4). This variable is meant to capture the degree of discretionary accounting: ahigher value of ACCOUNT implies a greater degree of discretionary accounting.
The coefficient on ACCOUNT is positive and significant. This finding is consistent
with our hypothesis that banks that are severely constrained by capitalrequirements tend to engage in discretionary accounting and the rolling over of badloans. This finding is consistent with Peek and Rosengren [2003] who use analternative way to estimate the same hypothesis by examining whether banks with
reported capital ratios closer to their required ratios are more likely to make loans
to weaker firms.
The above interpretation is based on the hypothesis that Japanese banks wereseverely constrained by capital requirements. In the next step we investigate thishypothesis by examining the effects of components of regulatory capital on badloans in detail. Regressions of bad loans on each component of regulatory capital
may reveal the banks’ attitude to capital requirements because banks can easily

23manipulate several components of tier 2 capital.20 We divide the RBC ratio into tier1 capital and the three major components of tier 2 capital, i.e., unrealized capitalgains on securities, general loan loss provisions, and subordinate debt, all of which
we divide by risk-adjusted assets.21 The variables for the three major components
are denoted by GAIN (for unrealized capital gains on securities), LOANLOSS(for general loan loss provisions) and SD (for subordinate debt). Banks with large
unrealized capital gains on securities and hence large true capital are expected torefrain from extending bad loans. Consequently, we expect the coefficient on GAIN
to be negative. The effect of general loan loss provisions on bad loans needs somediscussion. One might naturally suppose that banks with large bad loans tend toreport large general loan loss provisions. Alternatively, according to thediscretionary accounting view presented in the previous sections,capital-constrained banks are more likely to underreport general loan loss
provisions and to continue bad loans. The coefficient on LOANLOSS could
therefore be either positive or negative.
The effect of subordinate debt on bad loans is also ambiguous. If recapitalization
by subordinate debt diminishes the managerial incentive to extend bad loans as in
Proposition 3, we would expect the coefficient on SD to be negative. On the other
hand, if recapitalization works to promote bad loans as in Proposition 4, we would
expect the coefficient on SD to be positive.
The estimation result in column 5 shows that the coefficients on GAIN and

LOANLOSS are both negative, though only the latter is significant. The finding on
general loan loss provisions supports the hypothesis that capital-constrained banks
manipulate regulatory capital. The estimation result also shows that the coefficienton SD is significant and positive. This finding supports Proposition 4, according towhich, for a severely capital constrained bank, the ability to issue subordinate debt
strengthens the managerial incentive to continue bad loans.
We further investigate the perverse effect of subordinate debt on bad loans. In
March 1998 and March 1999, the regulatory authorities injected public money into
major banks by purchasing subordinate debt. The regulatory authorities may have24

had better access to bank information and been able to monitor bank risk-taking
behavior more intensively than the private agents that cross-held subordinate debt
within the same business group. Taking this supervisory effect into account, we
separate the subordinate debt held by private agents from the one held by thegovernment. The result in column 6 shows that the coefficient on subordinate debt
held by private agents, denoted by PSD , is significant and positive, while thecoefficient on subordinate debt held by the government, denoted by GSD isnegative but not significant. The government did not seem to effectively reduce the
incentive for banks to roll over bad loans.
Finally, we add four share ownership variables, i.e., MANAGER , KEIRETSU ,and their squared values (column 7). However, none of these turn out to besignificant.
We now turn to the estimation results for the regional banks. These aredisplayed in table III. Some of the results are similar to those for the major banks,
but others are not. Column 1 shows that, unlike in the case of the major banks, thecoefficients on ROA and PLAND are insignificant. In column 2, the coefficient on

RBC is also insignificant. Implementation of the Basel capital standards may nothave worked well to restrain regional banks’ risk-taking, though its perverse effectis not as clear as in the case of major banks. In column 3, the coefficient on MVC issignificant and negative. In column 4, ACCOUNT is significant and positive. Thisfinding seems to support the discretionary accounting hypothesis also for theregional banks.

(Table III should be placed around here.)

Dividing banks’ capital into subcategories, we find that the coefficient on SD issignificant and positive (column 5). This finding suggests that regional banks alsorolled over bad loans by issuing subordinate debt though subordinate debt as aproportion of risk assets is lower on average for the regional banks than for the
major banks (Table I). Among the share ownership variables, only MANAGER 2 is25

marginally significant (column 6).

F.

Determinants of subordinate debt levels
Our theoretical model predicts that banks with low true capital are more likely

to issue subordinate debt. To test this hypothesis, we estimate the determinants ofsubordinate debt. The sample period is the same as that of the baseline estimation,
1991–1999.
The dependent variable is SD and the explanatory variables are the same asin equation (4) above, except that the risk-based capital ratio is now calculated withsubordinate debt subtracted in the numerator. This adjusted risk-based capitalratio is denoted by ( RBC − SD ) . Table IV reports the results for the major banks. In
columns 1 and 2, we see that the coefficient on ( RBC − SD ) is significant andnegative, which is consistent with our theoretical prediction. Columns 3 and 4 showthat the coefficient on GAIN is significant and negative, which suggests that
subordinate debt was used to offset the decline in tier 2 capital caused by asset
depreciation. The magnitude of the coefficient in column 4 implies that for every
100 basis point decrease in unrealized capital gains on securities as a proportion ofrisk based assets, subordinate debt increases by 44.6 basis points. The coefficient on

PLAND is significant and negative in all specifications (columns 1 to 4). Taken
together, these results suggest that banks issued subordinate debt and tried torestore RBC ratios damaged by asset depreciation and worsening overall economic
conditions. These results are consistent with Ito and Sasaki [2002]) who conductedsimilar estimations for the period of 1990–1993.
The share ownership variables are also significant (column 4). Point estimatessuggest that both MANAGER and KEIRETSU have a positive effect on
subordinate debt for most of the relevant ranges (up to 0.15 percent for MANAGER
and up to 50.7 percent for KEIRETSU ). The latter result suggests that banks that
had close ties with financial institutions found it easier to issue subordinate debt on
non-market terms. Columns 5 to 8 show the results of our estimation of thedeterminants of privately-held subordinate debt, which are similar to the results

26

reported in columns 1 to 4.

(Table IV should be placed around here.)

Table V reports the estimation results for the regional banks. From the negative
coefficients on( RBC − SD) and its components we see that regional banks alsosought to repair damaged capital bases by issuing subordinate debt. The coefficientson PLAND and share ownership, however, are insignificant.

(Table V should be placed around here.)

V. CONCLUSIONSThis paper examined why soft budget problems emerged in the Japanese credit
market during the 1990s. We identified the Japanese bad loan problem as a softbudget constraint problem among three tiers of agents, the government, banks, andborrowing firms. At least to our knowledge, this paper is the first that formallyanalyzes the soft budget problem in a market economy. Our empirical results
suggest that poorly capitalized banks attempted to improve their RBC ratios jointly
by issuing subordinate debt and by rolling over bad loans. The government
responded to the banking problem by allowing the discretionary enforcement ofminimum capital requirements, which softened the budget constraints faced bybanks and contributed to the increase in bad loans.
The findings of this study have important implications for government policy
and how to resolve the banking problem. The theoretical model and the empiricalresults underpinning it suggest that there remains an incentive for poorly
capitalized banks to increase bad loans and hence recapitalization by thegovernment is likely to bring little improvement as long as bank managers are noteffectively controlled by outside shareholders, the accounting system is
discretionary, and the market for subordinate debt is poorly developed.
None of these conditions has been met so far in the course of the reconstruction27

of the Japanese banking system. Although the government encouraged a number ofmergers of major banks, the performance of these banks has not improved.
Non-performing loans have not declined but rather continued to increase until the
beginning of 2003.22 Values of deferred taxes accounted for a significant part of tier1 capital for many large banks. It was not until the end of 2002 that the government
began to recognize the harmful influences of discretionary accounting. What is more,market forces have just begun to play a role as foreign investors have gradually
been replacing keiretsu-affiliated firms as bank shareholders. On the other hand, amarket for subordinated debt has not yet developed. Only recently, Resona Bankand UFJ Bank, two major banks that emerged as a result of the mergers of smaller
outfits and that were recapitalized by the government in the late 1990s, fell into
financial difficulties once again.
This paper also provides new insights in the study of the effectiveness of capitalrequirements. While most studies struggle with the incentive problem of bankshareholders given that bank capital is verifiable (e.g., Koehn and Santomero[1980]; Gennotte and Pyle [1991]; Davies and McManus [1991]), this paper asks towhat extent the argument on capital regulation given verifiable bank capital is, infact, relevant. (If bank capital is actually banks’ private information, as our findings
suggest, the analysis in this field can be enriched by incorporating this moreplausible assumption.
The Japanese experience tells us what happens in the credit market whenbanks face high minimum capital standards but an accurate evaluation of bankcapital is difficult. A bank is an incentive-compatible means to efficiently control
agency problems associated with loan assets, as was shown by Diamond [1984] andBoyd and Prescott [1986]. As a result, bank loans are often not marketable andhence bank capital is not observable to or verifiable by outsiders. The government
may face difficulties in placing capital requirements at the center of prudentialbanking regulation.

28

Gakushuin University
Keio University

29

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(I would suggest to also

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31

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Footnotes
1. Hutchison and McDill [1999] report that the average duration of a banking crisis
is 3.9 years. For example, the crisis began in 1991 in Sweden and ended in 1994. It
began in 1997 In Korea and almost over in 2000.
2. As of March 1993, non-performing loans were estimated at 28.2 trillion yen;
however, this is less than the cumulative NPL write-offs amounting to 31.9 trillion yen
as of March 2002. It follows that the current stock of non-performing loans, worth 24.5
trillion yen as of March 2002, has been newly accumulated after 1993.
3. Lizar and Svejnar [2002], for example, defined firms that increased theirinvestment in spite of a decrease in cash flow as those subject to a soft budget
constraint and applied this definition to an empirical examination of Czech firms.
Their definition is indirect, however, in the sense that they do not measure thedegree of government support that relaxes firms’ budget constraints.
4. The empirical literature on soft budget constraints has a difficult time finding anempirical measure for the softness of the budget constraint. Kornai et al. [2003, p1100]
observe: “Unfortunately, the empirical measure of hardness and softness varyconsiderably from study to study and are sometimes quite rough. Furthermore, they are
typically not closely grounded in theory,…”.
5. Shrieves and Dahl [2003] investigated the accounting practices of Japanese banks
and found that less capitalized and less profitable banks tended to report greater
security gains and loan loss provisions than healthier banks.
6. Strictly, we assume risk-insensitive, flat-rate deposit insurance pricing, andnormalize the deposit insurance premium to be zero.
7. This might be a non-standard assumption in light of the literature on deposit
insurance under which facing the possibility of bank insolvency, the bank can exploit
32

the implicit subsidy from the fixed-rate deposit insurance scheme (e.g. Merton [1977]
and Keeley [1990]
8. This objective function is also employed in Rajan [1994], Aghion et al [1999], andMitchell [2001].
9. However, although we do not pursue this problem further in this paper, such a soft
policy would carry the danger that it provides banks with an ex ante incentive to choose
a riskier loan portfolio
10. As a matter of fact, the case of Hyogo Bank, a regional bank that failed in 1995, isthe last one when creditors of subordinate debt were not protected. Since then, creditorsof subordinate debt of failed banks have been protected.
11. Strictly speaking, the bank is always solvent to the creditors of subordinate debt
under the parameter space satisfying ( X − I ) + (YL − 2 I ) + A ≥ 0 . This can be proved asfollows. At the end of the period, the bank is obliged to repay (3I − A) to the depositors.
Creditors of subordinate debt are senior to equityholders, but junior to depositors, andso only if A + 2 X + YL + D0 ≥ 3I + D creditors of subordinate debt are fully repaid. If
A + 2 X + YL ≥ 3I , A + 2 X + YL + D0 ≥ 3I + D automatically holds because creditors are
satisfied with D 0 = D .
12. The Ministry of Finance allowed Japanese banks to count 45 percent of theirlatent capital gains as part of tier 2 capital in 1990. This is a special rule applied toJapanese banks, but not to banks in the United States or United Kingdom.
13. Hoshi [2000] first pointed out that Japanese banks increased the share of loans
to the real estate industry after the collapse of the real estate bubble until 1997.
14. Accordingly, while the loan share to the manufacturing sector was almost
constant about 15% over the 1990s, loan shares to the real estate sector and theconstruction sector rose from 11% to 13% and 5% to 6%, respectively. See Hosono
and Sakuragawa [2002] in detail.
15. The data are from the Financial Statement Statistics of Corporations publishedby Ministry of Finance.
16 Smith [2003] finds that Japanese banks charged lower interest rates than did foreignbanks on syndicated loans, and varied pricing less across risks than did foreign banks.
16. According to the Nihon Keizai Shinbun (June 13, 2001), among the total of
non-performing loans, real estate accounted for 32.8 percent, construction for 9.6
percent, and finance for 7.1 percent.
17. Though double gearing through subordinate debt was prevalent between banks
and life insurance companies, financial institutions’ shareholding ratio is themost-widely available measure for the closeness of keiretsu affiliation.
18. We have tested the null hypothesis that bank dummies are jointly zero and haveobtained results that reject the null in most of the equations.
19. Shrieves and Dahl [2003] followed a similar approach in order to investigate thebehavior of capital-constrained Japanese banks and the practice of discretionary
accounting.
20. We ignore land appraisal profits, tax effect accounting and other minor items.
21. Hoshi and Kashyap [2004] describe how severely Japan’s banks faced capital
shortage problems as of 2003.

33

0.16

0.14

MVC
RBC

0.12

0.1

0.08

0.06

0.04

0.02

Lo
ng
-T
er

Ho
kk

aid
o

Ta
ku
sh
Ni
ok
pp
u
on
Ba
m
Cr
Cr
nk
ed
ed
it
it
Ba
Ba
nk
nk
of
Ch
Ja
uo
pa
Tr
n
Ya
us
su
tB
da
an
Tr
k
us
tB
an
Sa
k
ku
ra
Ba
nk
Da
iw
a
Ba
nk
As
ah
iB
an
To
k
ka
M
i ts
iB
ui
an
Tr
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us
tB
In
du
an
Sa
st
k
nw
ria
a
lB
Ba
a
Da
nk
nk
iof
Ic
hi
Ja
Ka
pa
n
ng
yo
Ba
nk
Fu
ji
Su
Ba
m
Su
nk
ito
m
m
ito
o
m
Ba
o
M
nk
Tr
its
us
ub
tB
ish
a
iT
nk
ru
st
To
Ba
yo
nk
Tr
Ni
us
pp
tB
on
an
Tr
k
us
tB
an
k

0

Figure I
The risk-based capital ratio (RBC) and the market-valued capital ratio(MVC) for Japan’s major banks as of March 1997

Source: Financial statement of banks and Kabuka [Stock Price] CD-ROM
Note:

2002 published by Toyo Keizai Shimposha.
Market-valued capital is the number of stocks multiplied by theend-of-fiscal-year stock price. MVC is its ratio of the market-valued
capital to the sum of the market-valued capital and total debt.

34

0.12

0.1

Subordinate debt
Loan loss provisions
Unrealized capital gains on securities
Tier 1

0.08

0.06

0.04

0.02

Ho
k

ka
ido
Lo
Ta
ng
k
-T
Ni ush
er
pp
ok
m
o
u
Cr n CBed
re ank
it
dit
Ba
Ba
n
Ch k of nk
uo
Ja
pa
T
Ya
n
su r u stBdaaTr
us n kt
S a Bankura k
Da BankiwaB
As a n
k
ah
iB
an
T
o
M
its kai k
ui
Ba
Tr
us nk
In
t
du
B
S
st
ria anw ank
lB
a
Da
Ba
a
i-I nk
nk
of
ch
iK
Ja
p
an
gy an
o
Ba
nk
S Fu
Su um ji Baimito tom nk
o
m
M
B
o
its
an
ub Truk
ish sti T Bank
To rus
tB
yo
an
Tr
Ni
k
u
pp
on st B
an
Tr
k
us
tB
an
k

0

Figure II
Components of the risk based capital (RBC) ratio of Japan’s major banks
as of March 1997
Source: Financial statements of banks.
Note: The major components of capital as defined by the Basel capital
standards as a proportion of risk-adjusted asset are depicted.

35

100
90
80
70

trillion yen

60
50
40
30
20
Manufacturing
Construction
Commerce
Finance
Real estate

10

19
80
19
80
19
81
19
82
19
83
19
83
19
84
19
85
19
86
19
86
19
87
19
88
19
89
19
89
19
90
19
91
19
92
19
92
19
93
19
94
19
95
19
95
19
96
19
97
19
98
19
98
19
99
20
00
20
01
20
01
20
02

0

Figure III
Loans outstanding of domestically-licensed Japanese banks,
by industry of borrowing firms
Source: Bank of Japan, www.boj.or.jp
Note: Overdrafts before March 1993 were not included in the original data
source and hence estimated by the authors to obtain consistent timeseries data.

36

0.7

0.6

0.5
Long-Term Credit Bank
0.4

Nippon Credit Bank
Hokkaido Takushoku Bank

0.3
Average of surviving major
banks
0.2

0.1

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Figure IV
Share of bad loans in total loans: failed major banks
and the average of surviving major banks
Source: Financial statements of banks.
Note: Bad loans are defined as the sum of loans outstanding to the realestate, construction, and financial industries.

37

TABLE I
Descriptive statistics: 1991-1999

Total assets(trillion yens)
Return on assets (ROA)
Bad loan share
Change in bad loans
RBC ratio (RBC)
Market-valued capital ratio (MVC)
RBC ratio - Market-valued capital ratio (ACCOUNT)
Tier1
Tier2
Unrealized capital gains on securities (GAIN)
Loan loss provisions (LOANLOSS)
Subordinate debt (SD)Managers' shareholding ratio (MANAGER)
Fin. Inst.'s shareholding ratio (KEIRETSU)

Major banks
Mean Std. Dev.
18.92528.6550.00390.00580.09040.34500.0871
0.02110.01300.09610.03040.08170.03430.01430.01190.05480.00950.04130.01070.01400.00170.00360.01390.02330.00030.00040.11780.3282

Regional banks
Mean Std. Dev.
2.157
3.288
0.00200.00580.04520.22960.07800.04410.00900.09310.0186
0.06390.01750.02920.0111
0.06270.00780.03040.00830.01510.00100.00340.00820.01170.00580.00440.11120.4138

Coefficients of correlation with market-valued capital ratios (MVC)
RBC ratio (RBC)
RBC ratio - Market-valued capital ratio (ACCOUNT)
Tier1
Tier2
Unrealized capital gains on securities (GAIN)
Loan loss provisions (LOANLOSS)
Subordinate debt (SD)No. of obs.

-0.1054-0.9261
0.0721-0.23400.5788-0.0709-0.5738172

0.3597-0.8791
0.3446-0.0783
0.3550-0.0951-0.4018
497

38

TABLE II
The determinants of bad loans: Major banks
Dependent variable: Share of Bad Loans
Return on assets (ROA)
Rate of increase in land prices (PLAND)
Logarithm of assets (ASSET)(1)-1.261 *(0.680)-0.064 **(0.029)0.047(0.029)RBC ratio (RBC)(2)-1.352 *(0.694)-0.059 **(0.027)0.052 *
(0.030)0.460 *
(0.274)Market-valued capital ratio (MVC)(3)-1.380 *(0.702)-0.064 **(0.026)0.047(0.030)0.523 *
(0.278)-0.186 *(0.109)RBC ratio - Market-valued capital ratio (ACCOUNT)(4)-1.322 *(0.689)-0.068 **(0.027)0.043(0.028)(5)-1.778 **(0.669)-0.070 **(0.025)0.057 *
(0.030)(6)-1.966 **(0.648)-0.073 **(0.022)0.033(0.029)(7)-1.797 **(0.612)-0.075 **(0.023)0.051 *
(0.027)-0.084(0.451)-0.250(0.457)-3.495 **(1.451)
0.949 **
(0.390)0.077(0.426)-0.399(0.419)-3.489 **(1.365)0.714(0.494)-0.472(0.352)-2.717 **(1.321)

1.523 **
(0.460)-1.752(1.083)1.372 **
(0.518)-2.247(1.783)3.403(35.620)-11886.0-10017.5
0.323(0.550)-0.385(0.552)

172
23
0.967

171
23
0.969

0.218 **
(0.110)

Tier1
Unrealized capital gains on securities (GAIN)
Loan loss provisions (LOANLOSS)
Subordinate debt (SD)
Subordinate debt held by private agents (PSD)
Subordinate debt held by government (GSD)
Managers' shareholding ratio (MANAGER)Managers' shareholding ratio^2 (MANAGER^2)
Fin. Inst.'s shareholding ratio (KEIRETSU)
Fin. Inst.'s shareholding ratio^2 (KEIRETSU^2)
No. of obs.
No. of banks
Adjusted R2

172
23
0.961

39

172
23
0.962

172
23
0.963

172
23
0.963

172
23
0.964

TABLE III
The determinants of bad loans: Regional banks
Dependent variable: Share of bad loans
Return on assets (ROA)
Rate of increase in land prices (PLAND)
Logarithm of assets (ASSET)

(1)
0.097
(0.542)-0.011(0.009)-0.014(0.017)

RBC ratio (RBC)

(2)
0.121
(0.550)-0.010(0.009)-0.014(0.017)-0.048(0.125)Market-valued capital ratio (MVC)

(3)
0.232
(0.551)-0.010(0.008)-0.016(0.017)0.031(0.128)-0.161 **(0.051)

RBC ratio - Market-valued capital ratio (ACCOUNT)

(4)
0.163
(0.543)-0.011(0.008)-0.015(0.017)(5)
0.022(0.546)-0.006(0.009)-0.007(0.018)(6)
0.049(0.550)-0.006(0.010)-0.006(0.018)-0.196(0.153)-0.297(0.215)2.923(1.878)0.403 **
(0.181)-0.168(0.159)-0.329(0.233)2.669(1.881)0.395 **
(0.188)-0.747(0.500)13.364 *(7.597)
0.002(0.124)-0.126(0.165)
500
70
0.945

0.150 **
(0.049)Tier1
Unrealized capital gains on securities (GAIN)
Loan loss provisions (LOANLOSS)
Subordinate debt (SD)Managers' shareholding ratio (MANAGER)Managers' shareholding ratio^2 (MANAGER^2)
Fin. Inst.'s shareholding ratio (KEIRETSU)
Fin. Inst.'s shareholding ratio^2 (KEIRETSU^2)
No. of obs.
No. of banks
Adjusted R2

504
70
0.942
40

504
70
0.941

504
70
0.943

504
70
0.943

504
70
0.943

TABLE IV
The determinants of subordinate debt: Major banks
Dependent variable

Subordinate debt outstanding as a share of risk assets

Subordinate debt outstanding held by private
agents as a share of risk assets(1)
0.574 **
(0.184)0.574 **
(0.184)(3)0.655 **
(0.185)(4)0.671 **
(0.189)(5)0.243(0.154)(6)
0.242(0.150)(7)
0.262 *
(0.158)(8)0.261 *
(0.144)Rate of increase in land prices (PLAND)-0.009 *(0.005)-0.009 *(0.005)-0.010 *(0.005)-0.011 **(0.005)-0.008(0.005)-0.008(0.005)-0.009 *(0.005)-0.010 **(0.005)Logarithm of assets (ASSET)-0.020 **(0.009)-0.020 **(0.009)-0.019 **(0.008)-0.008(0.008)-0.015(0.010)-0.014(0.010)-0.014(0.009)0.000(0.007)

RBC ratio − SBD/Risk asset (RBC−SD)-0.337 **(0.093)-0.344 **(0.102)-0.211 **(0.082)-0.230 **(0.093)Return on assets (ROA)

Market-valued capital ratio (MVC)

0.006(0.038)

Tier1
Unrealized capital gains on securities (GAIN)
Loan loss provisions (LOANLOSS)

0.018(0.036)-0.195(0.121)0.010(0.117)-0.147(0.117)0.097(0.100)-0.380 **(0.140)0.349(0.301)-0.446 **(0.118)0.765 **
(0.285)-0.201(0.123)-0.118(0.306)-0.264 **(0.098)0.449(0.275)

Managers' shareholding ratio (MANAGER)

23.212 **(9.097)

14.699 *(8.056)

Managers' shareholding ratio^2 MANAGER^2)-7863.2 **(2720.3)
0.191 **
(0.084)-5985.1 **(2517.9)0.305 **
(0.083)-0.188 **(0.089)
171
23
0.907

-0.309 **(0.085)
171
23
0.904

Fin. Inst.'s shareholding ratio (KEIRETSU)
Fin. Inst.'s shareholding ratio^2 (KEIRETSU^2)
No. of obs.
No. of banks
Adjusted R2

172
23
0.895

172
23
0.895

41

172
23
0.894

172
23
0.883

172
23
0.883

172
23
0.880

TABLE V
The determinants of subordinate debt: Regional banks
Dependent variable

Return on assets (ROA)
Rate of increase in land prices (PLAND)
Logarithm of assets (ASSET)
RBC ratio − SBD/Risk asset (RBC−SD)
Market-valued capital ratio (MVC)
Tier1
Unrealized capital gains on securities (GAIN)
Loan loss provisions (LOANLOSS)Managers' shareholding ratio (MANAGER)Managers' shareholding ratio^2 (MANAGER^2)
Fin. Inst.'s shareholding ratio (KEIRETSU)
Fin. Inst.'s shareholding ratio^2 (KEIRETSU^2)
No. of obs.
No. of banks
Adjusted R2

Subordinate debt outstanding as a share of risk
assets
(1)
(2)
(3)
(4)
0.008
0.004
0.020
-0.061(0.179)(0.178)(0.181)(0.132)0.000
0.000-0.0010.000(0.002)(0.002)(0.002)(0.002)-0.017 **-0.017 **-0.019 **-0.019 **(0.003)(0.003)(0.003)(0.003)-0.404 **-0.408 **(0.035)(0.037)0.005(0.013)-0.427 **-0.415 **(0.041)(0.039)-0.319 **-0.310 **(0.053)(0.049)-1.429 **-1.384 **(0.475)(0.479)-0.160(0.119)1.222(1.911)-0.022(0.029)0.067(0.041)
497
497
493
497
70
70
70
70
0.909
0.909
0.911
0.923

42