Table of Contents

FDIC
 

Banking


Review
 

1998
 

Volume 11, No. 2
 

Chairman

Donna Tanoue

Division of Research

and Statistics,

Director

Wm. Roger Watson 

Deputy Directors

Barry Kolatch
 

Steven A. Seelig
 

Editor

Steven A. Seelig

Editorial Committee

Jack T. Reidhill
 

Detta Voesar
 

Managing Editor

Detta Voesar

Editorial Secretary

Cathy Wright

Design and Production

Geri Bonebrake 

The views expressed are

those of the authors and do

not necessarily reflect official positions of the Federal

Deposit Insurance Corporation. Articles may be

reprinted or abstracted if

the FDIC Banking Review

and author(s) are credited.

Please provide the FDIC's

Division of Research and

Statistics with a copy of any

publications containing

reprinted material.

Single­copy subscriptions

are available to the public

free of charge. Requests for

subscriptions, back issues

or address changes should

be mailed to: FDIC Banking

Review, Office of Corporate

Communications, Federal

Deposit Insurance Corporation, 550 17th Street, N.W.,

Washington, DC 20429.

Electronic Cash

by Kevin P. Sheehan Page 1

The author provides an overview of electronic cash, discussing the technology of this new medium of payment, the financial costs and benefits of moving

to electronic cash, and the issue of consumer acceptance. An appendix explores the relationship between counterfeiting and electronic cash.

Japanese Banking: A Time of Crisis

by Valentine V. Craig Page 9

This article explores the root problems that have led to the crisis in Japanese

banking and what is being done to resolve them.

Recent Developments Affecting Depository Institutions

by Lynne Montgomery Page 18

This regular feature of the FDIC Banking Review contains information on regulatory agency actions, state legislation and regulation, and articles and studies pertinent to banking and deposit insurance issues.
Electronic Cash

Electronic
 

Cash
 

by Kevin P. Sheehan*

Credit­card issuers in the United States have

begun to explore the idea of introducing electronic­cash products. Seven financial giants, including Wells Fargo, Chase Manhattan, and

MasterCard, have agreed to market the Mondex electronic cash product in the United States.1 VISA is developing a separate product. These products consist of

a plastic payment card and other accessories, and consumers can use them to pay for goods and services the

same way they use cash. Also like cash, consumers can

use them for making person­to­person payments.

These cards are equipped with microchips through

which funds can be electronically credited and debited. Users transfer money from their bank accounts to

their cards by inserting the card into an automatic teller

machine (ATM) or a specially adapted home (or public) telephone.

Mondex maintains that its card offers consumers a

number of benefits over traditional cash: 

It has an electronic locking system, which makes it

more secure than cash, and it is also more convenient and accessible [it eliminates the need to carry

coins and small notes, especially for routine daily

transactions where exact change is needed].

Because of the similarity to cash, payment transactions do not involve authorizations or signatures. . .

[Thus electronic cash is faster and easier than writing a check or getting a credit card authorization.]

[W]ith Mondex it is [also] possible to carry out immediate [cash withdrawals] using specially designed

pay phones, or private telephones providing customers with the convenience of a cash dispenser in

their homes. (Mondex press release)

But Federal Reserve economist Harvey Rosenblum

argues that "the current paper­based system doesn't

have much to recommend it, other than it works great,

is cheap, reliable, and we trust it" (quoted in Kutler

(1997), 4). Mondex co­inventor Tim Jones disagrees: 

Physical money has problems. It can be lost, it can

be stolen, and there are no records of cash transactions. You have to go to ATMs to get it . . . and you

can't send cash to someone down a telephone line.

Mondex overcomes these problems. . . . [U]nlike

physical money, Mondex can be sent down a telephone line. And unlike money in a bank account

there is no need to authorize a bank to make

Mondex payments or to check that funds are available; there are no signatures to be validated or PIN

numbers to confirm identities. Consequently there

is no delay. As with a straight cash transfer, the recipient gets purchasing power instantaneously.

(Quoted in Palmer (1994), 7.)

The dramatically declining cost of chip technology,

plus the potential benefits to banks, retailers, and consumers, are leading to the widespread introduction of

cash cards based on this microprocessor technology.

Electronic cash systems are up and running in

Denmark, Finland, Portugal, and Spain, while pilot

projects are under way in several other countries. In

fact, a high­profile New York City pilot is currently test

marketing both Mondex and VISA Cash.

*Kevin P. Sheehan is a financial economist in the FDIC's Division of

Research and Statistics.

1Wells Fargo will own 30 percent of Mondex USA; Chase will own

20 percent; and Dean Witter, AT&T, First Chicago NBD, Michigan

National Bank, and MasterCard will each own 10 percent.

1
 

FDIC Banking Review

The sections below provide an overview of this new

medium of payment, discussing the technology of electronic cash, the financial costs and benefits of moving

to electronic cash, and the issue of consumer acceptance. An appendix explores the relationship between

counterfeiting and electronic cash.

The Technology of Electronic Cash

The Bank for International Settlements reports that

more than 300 billion consumer cash transactions take

place in the United States each year, 270 billion of

which are for amounts under $2. Soon banks will be offering a coin card with the capability to displace cash as

the payment medium for a large number of these small

transactions. These coin, or payment, cards are designed to be used in an open system composed of multiple card issuers, acquirers, and merchants. (Cards

issued in an open system may be used to buy goods

and services offered by any participating merchants. In

contrast, cards issued in closed systems may be used

only to buy goods and services offered by the issuing

organizations. Washington's Metro farecard is an example of a card issued in a closed system.)

The transaction flow of an open system is illustrated

in figure 1. Issuing banks provide cards to consumers,

who load value onto these cards at specially adapted

ATMs (Load $A and Load $B in the figure).2

Consumers then use their cards at various designated

merchants (Pay $A and Pay $B in the figure). At the

Figure 1

point of sale, an electronic data­capture terminal

records both the value of the purchase and the routing

number of the issuing bank. At the end of the day, the

merchant submits the entire batch of electronic cash

transactions (Deposit $A +$B ) to his or her bank

(Acquiring Bank), which forwards the electronic receipts to the system operator (Claim $A +$B in the figure). The system operator transmits these claims to

the issuing banks, which then fulfill the interbank financial obligations resulting from the electronic­value

transactions. When these interbank transactions are

settled, the merchants are reimbursed by their banks.3

The coin card will be equipped with a microchip

through which funds can be electronically credited and

debited (see discussion below). Just as people now

withdraw cash by inserting a card into an automatic

teller machine, cardholders will transfer money from

their bank accounts to their coin cards in the same way.

This electronic purse will carry a running cash balance

in its memory. Each time the card is used, the purchase amount will automatically be deducted from the

card and credited to the merchant by an electronic

reader. (Merchants will store their electronic cash receipts in specially adapted point­of­sale terminals,

transferring accumulated balances to their banks at the

end of the day by means of telephone links.) Payments

will take just seconds. As with cash, no signatures will

have to be validated and no personal identification

numbers (PINs) will be needed to confirm identities.

2The figure illustrates a multipleissuer system; however, a singleissuer system would work in the

same way, also using multiple

banks: the single issuer would

create electronic value and issue

it to participating institutions,

which would then load this electronic value onto their customers'

payment cards. Cardholders

would use this electronic cash to

make payments to merchants,

who would later deposit these

funds with their banks; this value

would then be redeemed by the

issuer.

3Notice that cardholders may

make payments only to merchants, and merchants may clear

these payments, or deposit accumulated balances, only through

their acquiring banks. In other

electronic cash systems, transferability is much less restricted. In

systems like Mondex, cardholders are allowed to transfer value

freely among themselves; however, merchants still deposit the

electronic value received as payment.

Claims 

data 

Claims 

data 

Claims 

$ +$ A B 

Deposit 

$ +$ A B 

Claims 

$ +$ A B 

Deposit 

$ +$ A B 

Load 

$A 

Pay $A 

Pay $A 

Deposit 

$A 

Load 

$B 

Pay $B 

Pay $B 

Deposit 

$B 

Issuing 

Bank 

A 

Cardholder Merchant 

Issuing 

Bank 

B 

Cardholder Merchant 

System Operator 

Acquirer 

Y 

Acquirer 

X 

$ : electronic cash issued by Bank A 

$ : electronic cash issued by Bank B 

A 

B 

2
Electronic Cash

Transactions will be conditioned solely upon the storage on the card of enough value to cover the payment.4

The card is swiped through the electronic cash register

and the transaction is completed.5

Current forms of electronic payment-credit or debit cards-cannot function as a cost­effective alternative

for payments of very small value because of the costly

on­line authorization process by which security is

maintained. When a credit or debit card is presented

at the point of sale, the merchant swipes the card

through an electronic cash register that automatically

routes a request for authorization to the bank that issued the card. This electronic cash register reads the

cardholder's account information from the magnetic

stripe on the back of the card and forwards this information, along with the purchase price, to the card­issuing bank. After checking the account number against

a file of lost or stolen cards and verifying that funds (or

credit) are available, the bank sends confirmation that

payment is authorized.6 This authorization procedure

certainly enhances the security of the retail payment

system, but the telecommunication costs of this on­line

authorization process range from $0.08 to $0.15 per

transaction, depending on volume.7 These telecommunication costs generally preclude the use of credit or

debit cards for payments of very small value.

Recently, however, credit and debit cards have begun to penetrate the $55 billion per year fast­food market, where speed of service has always been at a

premium. To address this need for speed, card issuers

have streamlined the authorization process. For transactions at fast­food establishments, the credit­card in4Given the anonymity of these payments, anyone can spend the

electronic cash stored on a card. This anonymity exposes the cardholder to risk of loss-like cash in your wallet, electronic cash is lost

if your card is lost or stolen.

5Most cards store and manipulate a numeric ledger, performing

transactions as debits or credits to a balance. An alternative to

these "balance­based" products is electronic notes. Electronic

notes (often referred to as coins, or tokens) are issued in various denominations and stored on payment cards. In note­based systems,

transactions are performed by the transferring of notes from one device to another. If a card does not hold the necessary denominations for a particular transaction, change is made by reconfiguring

the notes on the card. 

6Because of high communication costs, banks in Europe use a semioff­line authorization process. Like cash, these systems economize

on telecommunication costs. Credit and debit cards, however, also

involve additional accounting costs. Monthly statements provide

the cardholder with transaction detail for each payment. (If one

were to use a credit card to purchase a cup of coffee each morning,

then one's statement would detail each coffee purchase over the

transaction period.) The bookkeeping cost of this record keeping is

economized by the use of cash for those small transactions that

need little documentation.

7See DePrince and Ford (1997).

terchange "stands in" for the card­issuing bank and authorizes the transaction after first checking the cardholder's account number against a central hot­card file.

If there is no match, payment is authorized and the

amount is billed to the customer's account. Since there

is no change and no sales slip to sign, the transaction actually takes less time than a cash transaction. But unlike cash, these transactions still require an on­line

authorization using telecommunication services. Semioff­line systems like those used in Europe and described below (see "Consumer Acceptance")

economize on these telecommunication costs-without, however, being able to address the need for speed.

Because the payor is required to enter a PIN at the

point of sale, card payments in semi­off­line systems

require more time than a cash payment

A cash payment does not require a telephone call or

PIN. Nor do electronic cash payments. The technology at the heart of an electronic cash system (the one

soon to be introduced in the United States, or any other) is a minute silicon chip, a microcomputer that is not

only capable of storing information, presenting it, and

transferring it to other, similar chips, but that also carries security programming. In other words, the microcomputer chips mounted on the backs of coin cards,

and similar chips residing in electronic cash registers

and automatic teller machines, can receive or store value or transfer it to one another and, more important,

can authenticate the validity of transactions among

themselves. As Tim Jones (co­inventor of Mondex)

explains, "Every time value is exchanged, the two

chips involved check that there has been no tampering

with the transaction en route. [Chip] Number One

says to [Chip] Number Two: 'I am a . . . member, are

you?' And only if they both check out will they exchange value" (quoted in Palmer (1994), 7). This security, however, extends only to the value encoded on

the card, not to the card's user.

For each transaction, the chip on the coin card releasing value and the chip in the electronic cash register accepting value confirm the authenticity of the

other by examining the chip's unique "digital signature." The chip's processing facilities are used to implement a cryptographic algorithm. This algorithm

generates a digital signature that must be authenticated by the receiving chip. This digital signature is the

guarantee that the chips involved are genuine-or,

more important, they guarantee that the signals have

not been tampered with. The availability of funds is

confirmed by the value stored on the card, and the authenticity of the electronic cash is confirmed by the

digital signature that accompanies each electronic cash

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FDIC Banking Review

payment. No on­line authorization using telecommunication services is required. (For a discussion of defenses against counterfeiting, see the appendix.)

Cost Savings and the Capital 

Investment

Electronic cash is starting to take off around the

world because it eliminates the costs to banks and retailers of handling coin and currency. The U.S.

Treasury estimates these costs at $60 billion annually in

the United States (approximately $0.20 per cash transaction).8 Electronic cash would limit these costs. 

For banks, which provide the public with cash and

therefore bear the cost of moving cash around the

economy, an area of significant savings would be the

cost of loading ATMs with paper currency. For retailers, there would be two areas of significant savings.

First, because electronic cash receipts would be reconciled electronically and transferred over telephone

lines directly from the store to the bank, sorting, counting, and transporting via an armored car would no

longer be necessary. Thus, costs related to handling

cash and coins would be reduced. Second, because

electronic cash payments would not involve making

change, retailers would not have to keep large amounts

of coins and small notes on hand-thus, there would be

little coin or currency to steal, and the security costs associated with robbery and employee pilfering would be

reduced (perhaps the most important areas of savings

for retailers). These potential savings alone explain

why banks and retailers are willing to invest in such a

capital­intensive cash­replacement technology.

Moving to electronic cash requires a large capital investment: payment cards must be provided to the

public; existing ATMs must be replaced or retrofitted;

and cash­only registers must be replaced by electronic

terminals. But the cost savings should easily finance

this capital investment.

Assuming only a 10 percent reduction of cash handling costs, cost savings over the next decade would be

sufficient to finance a $24 billion capital investment.

Approximately $2 billion of this total would cover the

cost of providing payment cards to the public (the cost

of payment cards runs somewhere between $2 and $10

apiece). From $1 billion to $7 billion would cover the

cost of replacing the banking system's 150,000 ATMs

(the cost of automatic teller machines runs somewhere

between $7,000 and $50,000 apiece). Another $15 billion could finance the purchase of up to 30 million new

cash registers (one new register for approximately

every eight people, with the cost of terminals running

somewhere between $500 and $2,000 apiece).

Consumer Acceptance

In late 1997, Chase Manhattan Bank and Citibank

introduced electronic cash on the Upper West Side of

Manhattan as part of a six­month trial. The pilot involves 50,000 consumers and 500 merchants, with

Chase issuing Mondex cards and Citibank issuing Visa

Cash cards. The test in New York is just one of many

around the globe (Mondex has 16 pilots in 6 countries;

Visa has 55 pilots in 17 countries). 

These electronic­cash pilots have shown that the

technology is effective, but they have also shown that,

for the most part, consumer demand is lacking.

Mondex, for example, was initially introduced in

Swindon, a city of 100,000 located south of London.

The first Mondex card there was issued in July 1995,

and a nationwide rollout was anticipated for the following summer. Today, nearly three years later, Mondex

in England is still issued only in Swindon, and only

13,000 cards are in circulation.9

One approach U.S. banks might use to address consumers' reluctance to accept the new payment instrument is to take an intermediary step and move to

semi­off­line credit and debit operations, such as those

currently used in Europe (see description below).

Semi­off­line credit and debit operations are much less

costly than the on­line system currently used in the

United States. For this reason, banks in the United

States are expected to move to a semi­off­line system

using smart cards during the next few years. (Smart

cards are payment cards equipped with a microcomputer capable of storing and processing information.)

A semi­off­line system as used by banks in Europe

differentiates between large and small payments to

economize on telecommunication costs. Large payments require an on­line authorization using telecommunication services, whereas payments less than the

minimum large payment are authorized off­line. The

payor simply enters an identification number at the

point of sale, a number that must match the PIN stored

8See U.S. Department of the Treasury (1996).
 

9Although the Swindon experience is representative, a few electronic­cash trials have been successful. In the Ontario city of

Barrie, more than 16,000 Visa Cash cards were issued in just three

months; in the Ontario city of Guelph, approximately 10,000

Mondex cards were issued in nine months; a Hong Kong pilot that

began in October 1996 has grown to 40,000 cards in circulation,

with 5,000 participating merchants. For an overview of the e­money developments in more than 65 countries, see Bank for

International Settlements (1997).

4
Electronic Cash

on the payment card; this PIN validation verifies card

ownership. The availability of funds is then confirmed

by a maximum charge limit also stored on the card.

This limit is debited upon every off­line payment and

is occasionally updated when the card is used with a

POS having on­line capability.

10

These payment systems do not impose a minimum

size for off­line payments; thus, payment cards in these

systems can be used for micropayments-that is, the

technology of these payment cards would provide

banks with a vehicle for paying interest on electronic

cash stored on debit cards. When the cardholder loads

cash onto the card, the bank will load an interest rate on

the card. 

For consumers, this multipurpose payment card

would provide numerous benefits. It would give them

"full micropayment capability, while freeing them from

balance awareness, reloading hassle, and situations of

purchase of newspapers, coffee, and other small­ticket

items. But card payments in semi­off­line systems require more time than cash payments, since the payor

must enter a PIN at the point of sale. For this reason,

payment cards are generally not used at fast­food

restaurants and other quick­service establishments.

And for small purchases generally, consumers in

Europe typically choose cash. A simple way of extending current credit and debit services into such

transactions, however, is for banks to take the next step

and load electronic cash on credit and debit cards, turning them into multipurpose payment cards. With these

cards, consumers would use on­line payments for large

transactions, off­line payments for small transactions,

and electronic cash for micropayments.

Making micropayments with multipurpose payment

cards would take just seconds. Payments would not

involve a PIN or authorization at the point of sale; each

time the card was used, cash would simply be transferred from the card to the merchant's terminal. When

micropayments reduced the card's cash balance to zero,

the cardholder would load more cash onto the card at

the merchant's terminal. Electronic cash would be

loaded in the same way an off­line payment is made: in

each case the cardholder would enter a PIN, and the

insufficient cash" (Teicher (1997), 5). Use of paper currency requires trips to the ATM. In contrast, cards in

an off­line system would function as remote ATMs by

enabling the cardholder to load electronic cash at any

merchant terminal, up to the card's charge limit.11

These payment cards would offer consumers the services of cash without the inconvenience of a trip to the

ATM. 

Today no electronic payment system operates like

the off­line system described above. In the system

proposed by Teicher (1997), payment cards would

function as remote ATMs, and electronic coins would

be stored on payment cards and merchant terminals.

When purchases reduced a card's cash balance to zero,

more coins would be loaded onto the card from the

merchant's terminal. But circulating electronic coins

are not necessary in an off­line system-and in fact,

they would introduce a problem endemic to paper currency systems: merchants would incur an opportunity

cost, since they would have to keep some coins on

hand for cash withdrawals.

The electronic cash described here would therefore

be much more accessible than paper currency, and

electronic­cash transactions would be faster and more

convenient. Transactions would be faster because concharge limit on the card would then be reduced by the

amount of either the purchase or the cash withdrawal.

For the cash withdrawal, the card's cash balance would

increase by the amount of the withdrawal. At the end

of the day, when the electronic receipt was returned to

the bank, the cardholder's deposit account (or line of

credit) would be reduced by the amount of the cash

withdrawal. Cardholders would receive a statement at

the end of the transaction period listing individually all

card payments as well as the cash withdrawals. Note

that off­line payments and cash withdrawals over the

transaction period would reduce the card's charge limit.

Like making credit­card payments, using electronic

cash stored on credit cards for small­ticket items would

defer payment and carry benefits such as accrual of

much­touted frequent­flier points. Alternatively, the

sumers would always have exact change-they would

not have to wait for change at the point of sale. And for

10Banks in France use a semi­off­line system, and today nearly 90

percent of all card payments are authorized off­line. Moreover,

since the implementation six years ago of this off­line system,

fraud losses in France have declined by 50 percent (see Svigals

(1998)). Payment in semi­off­line systems requires knowledge of

a PIN that is stored on a tamper­resistant smart card. The tamperresistant features of smart cards are aimed at protecting the PIN

and other critical data from unauthorized observation. Given the

secure storage of the PIN, fraudulent payments with stolen cards

are virtually impossible.

11With payment cards functioning as remote ATMs, this off­line

payment system would in effect make ATMs obsolete. With the

proposed semi­off­line system, banks would be able to reap the

savings of having fewer ATMs. Today there are approximately

150,000 ATMs deployed throughout the United States, and the

monthly operating costs per machine run somewhere between

$1,000 and $3,000 (see Belew (1997)).

5
FDIC Banking Review

transactions when exact change is required (for example, to board a bus or purchase something at a vending

machine), electronic cash would be much more convenient. Still, consumers would use this electronic cash

only if they expected it to be widely accepted. 

Conclusion

Electronic cash is meant to be a substitute for a paper currency, and paper currency is universally accepted as payment. To function as an adequate substitute,

therefore, electronic cash must have widespread acceptance. Current electronic­cash products have very limited acceptance. Electronic cash can be loaded on

payment cards in semi­off­line systems because these

systems employ smart cards that also function as coin

cards, but such systems are not in use in the United

States today. On­line systems, including the one currently used in the United States, use magnetic­strip

cards that do not function as coin cards. For this reason, electronic cash cannot be loaded on U.S. credit

and debit cards. 

Given the current incompatibility between electronic­cash products and consumers' needs, products issued by organizations like Mondex must operate as

stand­alone payment systems. In other words,

Mondex (for example) must introduce its product retailer by retailer, and few retailers are currently

equipped to accept its cash. 

In contrast, if electronic cash were stored on a multipurpose payment card that had widespread acceptance, it would be usable wherever credit and debit

cards were accepted. This electronic cash would piggyback on the worldwide network of existing retail

card­authorization devices. By leveraging the widespread acceptability of credit and debit cards, electronic cash stored on a multipurpose payment card would

offer the public a viable alternative to universally accepted paper currency. 

6
Electronic Cash

APPENDIX
 

Counterfeiting electronic cash will involve the creation of payment cards that other participants in the

system will accept as genuine-in other words, cards

capable of replicating a digital signature. To duplicate

a genuine payment card, one would need to procure a

card with the same type of chip and load the appropriate operating system and application software. One

would reconstruct the operating system and application software by examining genuine cards available

through legitimate channels. These cards, however,

are designed to prevent analysis and reproduction of

the contents of the device. More specifically, physical

barriers exist that prevent access to the application software stored on the chip:

Tamper­resistant features of these [smart] cards are

aimed at protecting data and software from unauthorized observation or alteration. . . . The software

code resides in the chip and is designed to be protected from any external observation or modification . . . Such features make it extremely difficult

and costly to observe or change critical data stored

on the chip . . . or to alter the operating system or

software applications. [This] hardware protection

. . . includes physical barriers that prevent optical or

electrical reading or physical alteration of the chip's

contents. . . . Physical barriers also include external

coatings as well as multiple layers of internal wiring

that are very difficult to remove without damaging

the chip itself. Active tamper­resistant features include sensors within the chip that detect unusual

levels of heat, light and electrical current and render

the chip inoperable under an attempted attack.

(Bank for International Settlements (1996), 14.)

To date there have been no reports of security

breaches of smart cards; nevertheless, "it can be assumed that even the most sophisticated tamper­resistant features may eventually be breached. . . . As a

result, continued strengthening of the tamper­resistant

features of card­based products will probably be necessary" (ibid., 22).

The tamper­resistant features of the payment card

represent one of the most important security measures

for electronic cash. But since these cards cannot be

viewed as impenetrable, issuers must monitor their

systems on an ongoing basis. In some cases, the security of electronic cash will be enhanced by the full accounting of individual transactions or the maintenance

of cumulative records on individual devices.

Alternatively, some systems will employ a value management strategy, which may be more manageable

than full accounting. These systems will use a statistical analysis of transaction patterns. Procedures will be

implemented to analyze system­level data on payment

flows in order to detect unusual volumes of payments

that could indicate fraud. Other methods to detect and

contain fraud include the issuer's or system operator's

periodic interaction by devices, and the hot­listing of

suspect devices. Maximum balances and expiration

dates on devices will also deter fraud as well as contain

any resultant losses. Moreover, some systems will have

the ability to change rapidly the cryptographic keys or

algorithms used if widespread fraud is detected or suspected.

7
FDIC Banking Review

REFERENCES
 

American Bankers Association. 1994. Stored Value Cards: Technology and Implementation.

Payment Systems Strategies. Summer. 

Bank for International Settlements. 1997. Survey of E-Money Developments. Basle.

---. 1996. Security of Electronic Money. Basle.

Belew, Joe. 1997. Comment: ATM Fees Aren't a Rip­off but the Price for Convenience. American

Banker April 24: 3-4.

DePrince, Albert E., and William F. Ford. 1997. The Privatization of Currency and Seigniorage.

Business Economics 32 no.1: 25-32.

Kokkola,Tom, and Ralf Pauli. 1995. Electronic Cash. Bulletin/Bank of Finland 68 no. 12: 9-14.

Kutler, Jeffrey. 1997. Fed Officials Minimize Smart Card Potential. American Banker May 7: 4-5. 

Palmer, George. 1994. Tim Jones: Mondex Mastermind. Banking World 12 no. 8: 7-9.

Schneier, Bruce. 1996. Applied Cryptography. John Wiley & Sons. 

Svigals, Jerome. 1998. Comment: Behind Smart Cards Lie Chances for New Revenue Growth.

American Banker January 15: 13-14.

Teicher, Mordechai E. 1997. Reestablishing the Business Case for Stored Value. Ultimus Ltd., KfarSaba, Israel.

U.S. Department of the Treasury. 1997. An Introduction to Electronic Money Issues. Washington,

DC.

8
Japanese Banking

Japanese Banking:
 

A Time of Crisis
 

by Valentine V. Craig*
 

Never really profitable, Japanese banks are in

crisis-a crisis into which they have been sinking for most of the past decade. This article

explores the root problems that have led to this crisis in

Japanese banking and what is being done to resolve

them. It begins by describing the different kinds of

banks and the protected niches in which they have

operated. It examines the banks' immediate problems:

problem loans resulting from the bursting of the "bubble" economy, a continuing soft economy, and lending

problems abroad. It then looks more closely at the

competitive problems caused by the very integral role

the banks have played, and continue to play, in promoting the government's industrial policy. The banks'

efforts to deal with their lack of competitiveness, as

well as the government's efforts to strengthen and

recapitalize the industry in the short term are then

described. Finally, the article touches on the government's proposals to deal with the financial industry's

long­term structural problems, the so­called Big Bang

financial deregulation proposals. A subsequent article

will explore the Big Bang reforms in greater detail. 

The Banking System

Since the end of the Second World War, the

Japanese financial industry has been highly segmented

at two levels. (Recent progress in this regard is

explained later in the article.) It has also been heavily

regulated, primarily by the Japanese Ministry of

Finance (MOF).

The Banks

Immediately after the Second World War, in an

attempt to eradicate the zaibatsu financial­industrial

conglomerates blamed for leading Japan into the

Second World War, the Japanese Diet (Parliament)

passed a series of laws restricting bank activities.

Holding companies were abolished. Banks were

restricted from engaging in securities and insurance

activities, and bank ownership of other Japanese companies was limited. In addition to this broad segmentation, the banking industry was further segmented

into five distinct categories of banks,1 each with its

specialized financial niche and corresponding restrictions: ordinary banks; long­term financial institutions;

financial institutions for small business; financial institutions for agriculture, forestry, and fishery; and public

financial institutions.

Until very recently, ordinary or commercial

banks-which include "city" banks, regional banks

and foreign­owned bank branches-were restricted to

providing short­term financing. Certain investment

*Valentine V. Craig is a Chartered Financial Analyst in the FDIC's

Division of Research and Statistics. The comments and suggestions of Rose Kushmeider of the Division of Research and Statistics

and of Louis Scalza in the FDIC's Division of Supervision are gratefully acknowledged. The assistance of Jennifer Zanini of the

Division of Research and Statistics and Alicia Amiel of the Library

staff is also gratefully acknowledged.

1The definitions and powers presented here are from U.S. General

Accounting Office, Bank Regulatory Structure, Japan, GAO/GGD­97­

5, December 1996.

9
FDIC Banking Review

banking services were also permitted. Commercial

paper underwriting, foreign exchange, trade financing

and some international securities activities were permissible activities. As of February 28, 1997, there were

10 city banks, 129 regional banks, and 92 foreignowned banks.2 These commercial banks together provided approximately two­thirds of all industrial loans.

The city banks were based in the large cities and were

supported by a network of nationwide branches. They

traditionally focused on short­term lending to large corporations. They also engaged in some securities activities and international finance. All city banks were also

licensed as foreign­exchange banks. For their funding,

they relied on Bank of Japan (BOJ) borrowings, the

short­term interbank market, and corporate deposits

(approximately one­half of their deposits were from

large corporate accounts). Regional banks were restricted to providing funding within their prefectures; their

customers were primarily small and medium­sized corporations and the interbank market. More than half of

their deposits came from individuals. Foreign-owned

bank branches in Japan functioned like city and regional banks. They accounted for a negligible amount of

industry deposits, loans or assets, but were active participants in the derivatives market. 

Long­term financing in Japan has been traditionally

provided by long-term financial institutions, a group

that includes 33 trust banks (8 of which belong to the

Federation of Bankers Associations of Japan) and 3

long­term credit banks. Until recently, these institutions were the only financial institutions in Japan permitted to raise long­term funds. 

The trust banks were licensed to conduct both banking and trust activities, and they and the life insurance

companies were given a virtual monopoly over most

Japanese pension fund investments. As major sources

of real­estate and development loans during the "bubble years" (the period of rapid and unsustainable escalation in the stock and real­estate markets in the

1980s), the trust banks currently account for a large percentage of the banking sector's nonperforming loans.

They were funded by individual and corporate

deposits held in trusts. The long-term credit banks provided funds to businesses for the purchase of plant and

equipment and for long­term working capital. Because

these banks were restricted from accepting deposits

from their own borrowers and the government, their

major source of financing had been the issuance of

debentures.

Nineteen large banks from these first two bank categories are considered Japan's "major" banks. They

include the nine remaining city banks, seven of the

trust banks, and all three long­term credit banks. The

city banks are Dai­Ichi Kangyo, Sakura, TokyoMitsubishi, Fuji, Sumitomo, Daiwa, Sanwa, Tokai, and

Asahi. The seven major trust banks are Mitsui,

Mitsubishi, Sumitomo, Yasuda, Nippon, Toyo, and

Chuo. The long­term credit banks are Industrial Bank

of Japan, Long­Term Credit Bank of Japan, and

Nippon Credit Bank.

Financial institutions for small business are the

third category of Japanese banks, which is composed of

approximately 800 mutual (shinkin) banks, credit associations, and credit cooperatives. These institutions

have traditionally provided funding to their members,

who are primarily small­ and medium­sized businesses,

consumer cooperatives, and labor unions. Their

sources of funds have been deposits and installment

savings provided by members (the shinkin banks also

accept deposits from nonmembers). Three national

federations act as central banks for these cooperative

banks. The Ministry of Finance supervises the mutual banks and credit associations, while regional governments supervise the credit cooperatives. The credit

associations and cooperatives have not been required

to disclose information about asset quality, but both

types of institutions, particularly the latter, were large

lenders in the Japanese real­estate market during the

1980s.

The fourth category of financial institutions consists

of financial institutions for agriculture, forestry,

and fishery. As of February 28, 1997, there were 47

credit federations of agricultural cooperatives and 35

federations of fishery cooperatives. These institutions

take deposits from and target their lending to local

cooperatives. The cooperatives exist at two levels: the

level of village, town, or city and the level of prefecture. Serving as the central bank for these institutions

is the Norinchukin Bank, which is regulated by the

Ministry of Finance and the Ministry of Agriculture,

Forestry, and Fishery. During the 1980s, this sector

was very active in lending to the housing loan companies, called jusen. 

The fifth category of Japanese financial institution is

that of public financial institutions: 11 wholly owned

government banks and 9 public corporations. These

public institutions are used to supplement private2Updated February 1997 data on Japanese banks are from the

Federation of Bankers Associations of Japan (Zenginkyo), FAQ

about Japanese Banks, http://www.Zenginkyo.or.jp/en/faq/a,htm.

One of the 10 city banks, Hokkaido Takushoku Bank, subsequently failed in November 1997.

10
Japanese Banking

sector financing. They are funded through the

Ministry of Finance, which is funded through the

Japanese Postal Savings System. The Japanese Post

Office, although not considered a bank, is certainly a

formidable banking competitor, for its savings system

has taken in approximately $2 trillion in savings-45

percent of all Japanese deposits. 

In addition to the five categories of banks, there are

a number of unregulated nonbanks-lending institutions that do not take deposits. These consist of insurance companies, housing loan companies (the jusen

mentioned above), leasing companies, consumer

finance companies, securities companies, and moneymarket dealers. 

Bank Regulation

The Ministry of Finance (MOF) and the Bank of

Japan (BOJ) share responsibility for monitoring the

safety and soundness of Japan's banking industry.

Other Japanese bank regulators are the Deposit

Insurance Corporation (DIC), which is responsible for

insuring bank deposits, and the Resolution and

Collection Bank (RCB), which was created in 1995 to

receive the assets of failed financial institutions. 

The MOF, which also supervises securities institutions, is the primary bank regulator. Its responsibilities

approximate those of the U.S. Department of the

Treasury, the Internal Revenue Service, the Office of

Management and Budget, the Securities and

Exchange Commission, and to some extent the

Federal Reserve Board.3 In its banking oversight, the

MOF establishes bank standards and has sole responsibility for bank licensing and for development and

enforcement of bank regulations. It also has sole legal

authority to take enforcement actions against financial

institutions, leading to fines, imprisonment, and revocation of licenses. For the most part, the MOF has taken supervisory action by issuing "administrative

guidance" on a case­by­case basis. Although the guidance provided through such notifications is not legally

enforceable, banks are expected to act upon MOF

guidance. 

The Bank of Japan-which until recently was under

the control of the MOF-is the nation's central bank

and has responsibility for maintaining and fostering a

safe­and­sound financial system. Although the BOJ

has no legal authority to take enforcement actions

against financial institutions, it provides advice to these

institutions through its frequent contacts with them.

As with the MOF's guidance, BOJ advice is typically

treated as binding by Japanese banks.

Effective April 1, 1998, the BOJ became independent of the MOF and its powers were expanded to

accord with those of other countries' central banks. In

light of recent scandals involving bribes to BOJ

employees, the Bank is being reorganized to encourage

central bank transparency and accountability.

Both the MOF and the BOJ may inspect or examine

banks at any time and with any frequency, although

each typically examines the average bank once every

two to three years. The MOF and the BOJ coordinate

their monitoring efforts to ensure that most banks are

examined annually. Since 1987, the MOF has used a

rating system similar to the CAMELS rating system

used by bank regulatory agencies in the United

States.4

The DIC was established in 1971 to protect depositors and maintain the stability of the financial system.

It is supervised by the MOF; the Minister of Finance

appoints its governor; and the MOF approves the

appointments of its executive directors and committee

members. In addition, the MOF must initially approve

all applications from financial institutions for financial

assistance. 

The DIC has authority to collect insurance premiums, pay insurance claims and advance payments, provide financial assistance, purchase assets from failing or

failed financial institutions, and manage funds. It

insures deposits up to a maximum of 10 million yen per

depositor (approximately $73,400).5 Excluded from

coverage are interbank deposits, deposits in foreign

currency, deposits in foreign banks and in overseas

branches of Japanese banks. Membership in the system is mandatory for city banks, long­term credit

banks, trust banks, and certain other banks.

In 1991, for the first time in its history, the DIC

arranged an assisted merger of an insolvent institution

with a stronger institution. Between 1991 and 1993

there were four more assisted mergers. In 1995, the

RCB, modeled after the U.S. Resolution Trust

Corporation (RTC), was created to receive the assets of

failed financial institutions. 

The Diet recently enacted legislation that (1) granted the DIC the authority to issue 3 trillion yen ($22 bil3"Scandal Erodes the Power of Japan's Bastion of Fiscal Austerity,"

The New York Times (March 17, 1998), D1.

4The acronym CAMELS refers to capital, asset quality, management, earnings, liquidity, and sensitivity to market risk.

5All dollar­yen exchange rate calculations are based on an exchange

rate of 136.27 yen to the U.S. dollar, the late New York spot rate on

May 14, 1998.

11
FDIC Banking Review

lion) of government bonds; (2) provided government

guarantees for the DIC to borrow 10 trillion yen ($73.4

billion); and (3) amended the Deposit Insurance Law

to allow issuance of 7 trillion yen ($51.4 billion) of government bonds to compensate for commercial bank

losses. Previously, the DIC had been allowed to borrow up to 2 trillion yen ($14.7 billion) from the BOJ. 

The Problems

Japanese banks' distress is caused by both immediate and long­term problems. Speculative lending in

Japan during the bubble years of the 1980s created a

severe domestic bad­loan problem, and a more recent

concentration of lending to Southeast Asia businesses

resulted in foreign loans that also are expected to be

problematic. The more difficult problems facing

Japanese banks, however, are longstanding competitive problems resulting from the government­industrybank relationship. 

Bursting of the "Bubble" Economy

The immediate problem facing Japanese banks is

their bad loans. The Japanese Ministry of Finance

reported in January 1998 that its best estimate of the

extent of domestic bad loans was 77 trillion yen

(approximately $565 billion)-approximately 14 percent of total domestic loans. Although MOF audit

requirements were used to arrive at this estimate, the

estimate is based upon bank self­assessment and may

therefore underestimate the extent of the problem.

Since the January announcement, bad­debt levels have

also reportedly increased quite substantially and are

expected to continue increasing in the coming

months.6

Many of these problem loans were made during the

bubble years, when the long­term financial institutions

and the financial institutions for agriculture, forestry,

and fishery, the latter particularly, lent vast sums to

commercial real­estate developers and home buyers

either directly or through the jusen (housing loan companies financed by the banks). But the real­estate and

stock markets began to crash in earnest in 1990, bringing an end to the bubble economy. By some estimates,

today's real­estate prices in Japan represent an amazing

80 percent decline from their highs in the 1980s.7

Although some major banks have made large provisions to cover jusen­related exposures, overall the banks

have been slow to recognize their losses and rid themselves of these problem loans. With this overhang of

unsold problem real­estate loans, the real­estate market continues to languish. 

In the mid­1990s a government effort to bail out the

jusen with taxpayer funds was met with tremendous

resistance by the Japanese people; and until recently,

that resistance deterred the government from providing taxpayer funds to deal with the banking crisis. A

complicating factor in the resolution of the bad­loan

problem in Japan, and a reason for public opposition to

a government bailout of the jusen, is that many of the

borrowers from the jusen are rumored to be members of

the yakuzi, the Japanese underworld. A very detailed

report on the jusen by the MOF and the Ministry of

Agriculture, Forestry, and Fisheries, issued in January

1998, reinforced this belief when it inexplicably omitted the names of the largest jusen borrowers, all realestate brokers.

Japanese banks were also substantially affected by

the precipitous drop in the Japanese stock market that

began in 1990. As with the real­estate market, the

stock market has declined dramatically-approximately 60 percent from its highs during the bubble years.

Although Japanese banks were not permitted to hold

directly more than 5 percent of the shares of another

company, an estimated 30 percent of the equity of

Japanese industrial companies is held by banks indirectly.8 Larger banks in particular are thought to have

effective control over other companies by their indirect

ownership through subsidiaries and affiliates and by

cross­shareholding arrangements, interlocking directorships, and credit relationships. 

Until recently, bank stock investments in Japan had

to be valued at the lower of cost or market, and banks

were allowed to use 45 percent of their "hidden

reserves"-the unrealized gain on equity holdings-to

meet international capital requirements. Any decline

in the Japanese stock market therefore decreased the

banks' capital and their lending ability. Because of

continuing slippage in the Nikkei, it has been estimated that the largest banks' hidden reserves at the end of

fiscal 1998 (March 31) represent 10 percent of their level a year earlier, with 8 of the 19 largest banks no longer

having any hidden reserves left. It has been calculated

that no hidden reserves will be left at any of the largest

banks if the Nikkei goes beneath 16,201.9

6"Japan Banks Dumping Bad Debts, Incurring Large Losses,

Sources Say," BNA's Banking Report 70, no. 14 (April 6, 1998):

583-84.

7"The Japan Puzzle," The Economist (March 21, 1998): 22.

8Anthony Saunders and Ingo Walter, Universal Banking in the United

States: What could we gain? What could we lose? New York, Oxford

University Press (1994), 84-86.

9"Japanese Banks Dumping Bad Debts, Incurring Large Losses,

Sources Say," BNA's Banking Report 70, no. 14 (April 6, 1998):

583-84. The Nikkei was 15,014 on June 11, 1998.

12
Japanese Banking

The economic problems that have so seriously

affected Japan, and Japanese banks, show no sign of

abating. In fact, they appear to be worsening. Japan's

Economic Planning Agency reported in June that the

country had entered its first recession since the oil crisis in the 1970s. Its gross domestic product shrank an

annualized 5.3 percent in the first quarter of 1998, following a 1.5 percent annualized decline in the fourth

quarter of 1997. Its gross domestic product for the fiscal year (ending March 31, 1998) also fell-by 0.7 percent-the first fiscal year decline since 1975. The

unemployment rate has been steadily rising, reaching

4.1 percent in April. This level, although low compared to international norms, is remarkably high for

Japan. Additionally, as of June 12, the yen had sunk to

an 8­year low against the dollar. The stock market

remains in the doldrums, and recently, at the 15,000

level, the Nikkei has been testing its 1995 lows.

Bankruptcies, both corporate and personal, are on the

rise, and finally, it is not at all clear that real­estate

prices, down an estimated 80 percent from their highs

in the 1980s, have bottomed out. 

Problems in Foreign Lending

The foreign lending of Japanese banks has also produced problems. As big lenders to Southeast Asia,

Japanese banks are expected to suffer substantial losses from this exposure. 

Many Japanese banks responded to the poor conditions in the domestic market by stepping up their foreign lending. Foreign loans and other assets account

for approximately 22 percent of the assets of Japan's 20

largest banks.10 However, foreign lending has produced problems of its own. Because much of it is done

in dollars and accounted for in yen, recent appreciation

in the dollar has resulted in an increase in the yenamount of loans outstanding, forcing banks to set aside

more capital to meet Bank for International Settlements minimum reserve requirements. But a more

pressing problem is that much of Japanese banks' foreign lending was made to Southeast Asian companies.

The Bank for International Settlements reports that

Japanese banks hold at least $276 billion in loans to

businesses in Asia. This Asian exposure by Japanese

banks is approximately six times that of U.S. banks and

twice that of German banks.11 While some of these

loans are reportedly to Japanese companies operating

in Asia, much of this foreign lending may be unrecoverable. Even more ominously, these Asian economies

have been major markets for Japanese goods, accounting for more than 40 percent of Japanese exports. The

crisis in Southeast Asia is therefore expected to reverberate throughout the Japanese economy. 

Structural Problems

The greater problem for Japanese banks is that they

are not competitive, because of structural reasons.

According to Moody's Investors Services, Japanese

banks-with historical return­on­assets ratios of 0.43

percent-are the world's least profitable, even disregarding problem loans.12 Thus, if and when the problem loans are disposed of, Japanese banking will still

remain unprofitable and unable to compete internationally unless structural changes are made. To understand the reasons for this lack of competitiveness, one

must understand two relationships: the one between

Japanese industry and the Japanese government, the

other between the banks and other Japanese businesses (called the keiretsu relationship). 

The power of the Japanese government over the

financial affairs of Japanese banks is tremendous. For

example, until the summer of 1991, the BOJ, under the

direction of the MOF, assigned each bank each quarter

the net amount of new lending it was authorized to

make.13 This power is exerted to achieve one objective. As set forth by the Japanese government, the

overriding purpose of Japanese banks has been to act

as intermediaries in recycling Japanese savings to

Japanese industry. Following the Second World War,

the government-particularly the very powerful

Ministry of Finance-successfully built and directed a

banking system whose single goal was to support

Japanese industry with the cheapest possible cost of

capital. As one analyst has said, Japan has the only

banking sector in the world dedicated to the cause of

full employment.14 Bank loans in Japan remain the

major source of corporate finance, far overshadowing

the stock and bond markets as sources of capital.

Savers (who receive 0.1 percent annual interest on their

time­deposit accounts) and the banks (whose large customers typically pay loan interest rates of between 12.5

and 25 basis points above the bank's cost of funds) have

been sacrificed by the government to the cause of

industrial production. 

10"Raging Dollar Threatens Tokyo's Banks," The Wall Street Journal

(February 13, 1997), A12.

11"Moody's Gauges Risk Exposure of Worldwide Banks to Asian

Crisis," BNA's Banking Report 70, no. 10 (April 10, 1998): 407.

12"Japan's Sick Banking System," The Economist (March 9, 1996): 71

13Ibid.

14"Why Japanese Banks Don't Care about Profits," Euromoney

(February 1998): 66-70.

13
FDIC Banking Review

But in return for carrying out national industrial policy and lending at rock­bottom rates, banks were protected from global and domestic competition and

received tacit government assurance of a bailout should

problems arise. Historically, when a Japanese financial

institution was in difficulty, other healthy institutions,

at government urging, would act as a "convoy" and

rescue the failing institution by providing liquidity to

it, or agreeing to merge with it. 

This tacit government­directed guarantee allowed

Japanese banks to ignore credit quality in pricing loans.

Thus, they severely underpriced their products; and

low margins, in turn, pushed them to pursue a strategy

of volume lending. The average spread between loans

and deposits has also narrowed over time, declining to

171 basis points in September 1995 from 230 basis

points in March 1991.15

Inherent conflicts of interest have allowed this lack

of bank profitability to go unchallenged. Large corporate customers reportedly own more than 50 percent of

the shares of Japanese banks, so it is easy to understand

the lack of stockholder attention to loan mispricing.16

Here it is important to grasp the concept of the keiretsu.

Keiretsu are closely knit groups of Japanese businesses

that, sanctioned by the government, work together

cooperatively to achieve group goals. They are affiliated through cross­shareholding agreements. Six keiretsu

in Japan have a large commercial bank at their center,

with the rest of the group composed of trust banks, life

and nonlife insurance companies, and trading, construction, finance, and real­estate companies. The

banks in the keiretsu are both lenders to and stockholders of the other businesses; the other businesses are

both stockholders of the banks and the prime beneficiaries of the banks' low­cost loans. Keiretsu members

are also frequently on the bank's board of directors, and

bank officials are frequently on the boards of the other

firms.

Government industrial policy and the inherent conflicts of interest in the keiretsu relationship have produced an unprofitable banking sector. However,

because banks operate in protected niches, with a guaranteed level of "appropriate" profits, they have not

pursued more­profitable financial services. For

instance, two lucrative services provided by global

banks today-loan securitization and interest­rate

swaps-are foreign innovations that Japanese banks

have ignored. Until very recently, Japanese banks

rarely engaged in securitization, and their use of derivatives was severely restricted. Some Japanese banks

have begun securitizing their problem­loan portfolios,

but have used foreign financial institutions, mostly

located in London, to do so-even for Japanese securities issued in yen and sold back to Japanese investors.

Japanese banks are also markedly low­tech, and they

have not been able to take advantage of arbitrage

opportunities created by disequilibriums in foreign or

domestic markets.

Unlike the situation in most countries, the two most

powerful departments in Japanese banks are corporate

planning (whose members interact with the MOF) and

personnel (whose members oversee the careers of

bank employees). The careers of Japanese bankers are

still virtually governed by seniority. An employee's

bonus is guaranteed; his rank and pay are basically

identical to all other employees of his age (Japanese

bankers continue to be predominantly male); and the

route to promotion is inflexible.17 Heads of departments or major branch managers are often elevated to

board membership as recognition of their service.

Boards tend to be very large (Tokyo-Mitsubishi, for

instance, has 60 board members), and it is not considered respectful for board members to question corporate decisions.18

What Is Being Done

In response to their problems, some banks, most

particularly the major banks, have begun to dispose of

their problem loans and to undertake modest downsizing, cost­cutting, and business­shifting activities. The

Japanese government has also initiated some shortterm fixes to help the banks; and has proposed some

reforms, some of which have been enacted, to deal

with the underlying lack of competitiveness of the

Japanese financial sector, the so­called Big Bang

reforms.

Banks' Actions

The major Japanese banks have begun to deal with

their problem loans. Many other Japanese banks, however, have been slow to dispose of their problem loans

because lending opportunities have been limited, bond

15"Japan's Banks Struggle with Many Problems, Spur Slump in

Stocks," The Wall Street Journal (January 22, 1997), A1.

16"Why Japanese Banks Don't Care about Profits," Euromoney

(February 1998): 66-70.

17Euromoney reports that bank presidents must serve a stint as director of corporate planning, with approximately 23 years necessary

for advancing from an entry­level bank employee to a division

head in corporate planning.

18"Why Japanese Banks Don't Care about Profits," Euromoney

(February 1998): 66-70.

14
Japanese Banking

yields low, and a government bailout (now announced)

was long expected. For the 1996 fiscal year ending

March 31, 1997, the 19 major Japanese banks disposed

of 6.17 trillion yen ($45.3 billion) in nonperforming

loans,19 double the volume disposed of the previous

year. The Bank of Tokyo-Mitsubishi reported that it

wrote off $8.4 billion in problem loans, and Fuji Bank

reported plans to sell $25 billion in loans to build its

capital base.20 Fiscal 1997 bank records are not scheduled for release until later in 1998, but it has been

reported that the large banks will be writing off 10.219

trillion yen ($75 billion) in nonperforming loans for this

period.21

Virtually all buyers have been foreigners, for

Japanese life insurance companies have shown little

interest in entering this market. E&Y Kenneth Leventhal estimates that by the beginning of 1998, $20 billion in foreign money had been invested in problem

loans and distressed properties. Most of the deals were

bulk sales; buyers were expected to securitize and sell

them when restrictions on securitization end this year.

In addition, some banks have initiated modest

downsizing, salary decreases and branch closings.

Downsizing and cost cutting was required initially for

all banks planning to take advantage of the DIC's 13

trillion yen assistance program (described below).

Among the larger banks, the Bank of Tokyo­Mitsubishi

announced planned staff reductions, branch closings,

and pay cuts. Sanwa Bank is planning staff reductions

of 1,300 employees over the next three years. It also

plans to reduce the number of directors from 43 to 30;

to cut compensation; and to consolidate or to close 60

branches in Japan and 5 branches overseas during the

next three years. Sakura Bank will close as many as 23

overseas branches.22 Sumitomo Bank's Californiabased operations are being purchased by Zions

Bancorporation (Utah).23 However, despite some cost

cutting, Japanese bank salaries continue to be higher

than salaries in other Japanese industries. They are

also higher than bank salaries in other countries, a fact

that is particularly interesting inasmuch as Japanese

banks, unlike many of their international peers, do not

provide investment banking services, typically a more

lucrative banking specialty.

The keiretsu relationships are also changing.

According to recent reports, cross­shareholdings (the

glue of the keiretsu arrangements) have declined, dropping from 55 percent of total shareholdings 10 years

ago to 47 percent today.24 And the "convoy" system

has begun to unravel. Nissan Mutual Insurance

Company, Sanyo Securities, Hokkaido Takushoku

Bank, and Yamaichi Securities are all companies that

were recently allowed to fail. It was reported that nine

life insurance companies rejected Sanyo's request for a

postponement of its loan payments. However, the convoy system is not completely finished. Many analysts

see the recent requests by the major banks for government financial assistance as their capitulation to MOF

demands that they provide protective camouflage for

weaker banks in need of assistance. In particular,

Sanwa Bank, one of the healthiest Japanese banks,

recently applied for a loan of 100 billion yen that was

generally seen as unneeded.25

In response to changing conditions, some banks

have changed their business mix. Lending activity has

been curtailed; construction companies, in particular,

report that their lines of credit have been shut down.

Larger numbers of commercial banks have been entering the bond business, gaining a market share of 60

percent in the year ending March 1997, up from 36 percent a year earlier.26 Long­term credit banks, having

lost their monopoly on providing long­term credit,

have shown an interest in entering asset management.

Two of the three long­term credit banks, Nippon

Credit Bank and Long­Term Credit Bank of Japan,

allied themselves last year with Bankers Trust and

Swiss Bank Corp., respectively, to strengthen their

global asset management capabilities. The third longterm credit bank, Industrial Bank of Japan, is actively

seeking a comparable alliance.

Short-Term Government Fixes

The Japanese government has tried to help the

banks both indirectly, by stimulating the economy, and

directly, by providing cash to the industry. It has pur19"Japanese Banks Dumping Bad Debts, Incurring Large Losses,

Sources Say," BNA's Banking Report 70, no. 14 (April 6, 1998):

583-84.

20"Bank of Tokyo­Mitsubishi Write­off of $8.4 Billion Could Spur

Other Banks," The Wall Street Journal (September 12, 1997), A16.

21"Japanese Banks Dumping Bad Debts, Incurring Large Losses,

Sources Say," BNA's Banking Report 70, no. 14 (April 6, 1998):

583-84.

22"Top Japanese Banks Seek Help to Show Intent to Fix Sector,"

The Wall Street Journal (March 5, 1998), A19.

23"Sumitomo Bank Seeks to Sell Some U.S. Lines," The Wall Street

Journal (December 5, 1997), A3.

24"Japan Girds for Changes on Lending," The Wall Street Journal

(October 24, 1997), A14.

25"The Japanese Banks Seek Help to Show Intent to Fix Sector,"

The Wall Street Journal (March 5, 1998), A19.

26"Japanese Securities Firms: Once There Were Four," The Economist (September 27, 1997): 80.

15
FDIC Banking Review

sued a very easy monetary policy, dropping the official

discount rate to 0.5 percent in 1995, where it remains.

However, many analysts feel that this loose monetary

policy, rather than restarting the economy, has caused

excessive borrowing and overcapacity. With rates this

low, the government is also no longer in a position to

use monetary policy as a tool to spur the economy. 

The government has also tried to export its way out

of its problems. But because of resistance from the

United States and Europe and the financial problems

in Southeast Asia, an export­led expansion no longer

appears a viable strategy for overcoming domestic

Japanese stagnation.

The Japanese government has also tried to stimulate

the economy by direct infusions of money. It injected

75 trillion yen ($550.4 billion) into the economy

between 1992 and 1995, with approximately half dedicated to public works investments. The economy

began to show some signs of growth in the spring of

1997, at which point, to gain control of its budget

deficit, the government raised the consumption tax,

slashed public spending, raised welfare contributions,

and withdrew temporary tax concessions, throwing the

country into recession.

Another stimulus package has recently been

announced. On March 26, 1998, the Liberal

Democratic Party announced a plan, subsequently

enacted, to spend 16.6 trillion yen ($121.8 billion) in

public works investments and temporary tax cuts to

stimulate the economy. This is the largest stimulus

package ever enacted in Japan. Approximately twothirds of the money will go to public works, including

less traditional targets of public investments such as

information technology, telecommunications, education, urban redevelopment, and disaster prevention.

Supporters of the plan also claim it includes "decisive"

measures to address the bad­loan problem, including

tax incentives to encourage the disposition of bad loans

more quickly and a promised overhaul of the tax system. Many analysts are not optimistic about this new

stimulus package, because much is concentrated on

public works spending which, in the past, appeared to

help only the construction industry, and only in the

short run at that. Without permanent tax cuts-which

are politically difficult to enact because they would

require the issuance of deficit­financed bonds, currently prohibited by a fiscal reform law-it is feared that

the Japanese people will use any temporary windfall

for savings rather than consumption. 

The government has directed special assistance to

the banks. Some of this assistance has manifested

itself in government actions to disguise the true extent

of the banks' financial problems. For instance, for

years the Japanese government used "price­keeping

operations"-government manipulation of the stock

market-to improve the balance sheets of financial and

other companies. Just before the end of the fiscal year,

the government would purchase huge amounts of

stock on the Nikkei, thereby artificially inflating the

financial statements of the banks, which are large holders of publicly traded stock. As discussed above, the

banks were permitted to use some of the unrealized

gains on these stock investments as hidden reserves to

meet capital requirements. 

Price­keeping operations were discontinued in the

mid­1990s but were resurrected this year to improve

the banks' reported financial condition for the 1997 fiscal year, which ended March 31, 1998. On March 30,

1998, the Postal Ministry announced that $7 billion

from postal savings and insurance accounts was being

transferred to trust banks for their purchase of stock in

Japanese companies. Unlike in previous years, however, this time the strategy did not work. It is unclear

whether the trust banks participated to the degree

expected, but in any case, sellers quickly jumped into

the market, causing the Nikkei to fall to 16,527 on

March 31, far short of the government goal of 18,000.27

The government, in an act reminiscent of the

behavior of U.S. regulators during the savings­and­loan

crisis, has recently initiated accounting rule changes to

allow the banks to meet their capital requirements.

Financial reporting requirements have been changed

to allow banks to value their equity holdings at historical cost, a change that effectively places a floor on

expected capital losses caused by the prolonged stock

market decline. Another change allows banks the

option of carrying their real­estate holdings at market. 

The government has postponed implementing

reforms that would cause some banks to be declared

insolvent. In 1996, the Diet passed several bills to

strengthen the deposit protection system. In particular, a "prompt corrective action" system, changing the

method for calculating capital adequacy ratios to follow

international standards more closely, was to have been

adopted on April 1, 1998. These capital adequacy

ratios would have required specific corrective actions:

institutions with less than 8 percent capital would have

been required to prepare a management improvement

27"Japanese Plan to Boost Nikkei Stock Index Fails," The Washington

�ost (April 2, 1998), C1.

16
Japanese Banking

plan; those below 4 percent capital would have needed

to implement specific corrective measures; and those

below 0 percent would have been required to suspend

operations. Implementation of this system for institutions involved in domestic business has been postponed until April 1999 to give the affected banks time

to clear up their bad­loan problems. Internationally

active banks are still subject to the rules.

The government is now also supplying cash directly

to the banks. The Liberal Democratic Party recently

announced a 30 trillion yen ($220.1 billion) program to

stabilize the financial system. Thirteen trillion yenin the form of purchases of preferred stock, subordinated bonds, or loans-was to be made available by the

Deposit Insurance Corporation for selected investments in weak but viable banks that were implementing prompt corrective action measures. As announced,

the terms of the assistance required the banks to cut

costs, write off problem loans, prepare ethics guidelines, and provide more information on their activities.

However, the standard­setting committee established

by the legislation backed away from these requirements and recently held that the criteria were not binding and that all banks, regardless of financial or ethical

weakness, could apply.28 In fact, as mentioned above,

all banks have been encouraged to apply in order to

provide camouflage for the truly needy banks applying

for assistance. The remaining 17 trillion yen of the 30

trillion yen financial stabilization package is being provided to the DIC to shore up its deposit fund. 

Long-Term Government Fixes

Stock market manipulation, accounting rule changes

to improve reported financial results, financial infusions-these are the short­term government fixes to

the banks' problems. The government has also initiated dozens of reforms designed to make the Japanese

financial industry more competitive over the long run.

Announced by Japanese Prime Minister Ryutaro

Hashimoto on November 11, 1996, these reform proposals are called Japan's Big Bang, in reference to the

decade­earlier British experience in deregulating its

securities markets. 

The Big Bang proposals are designed to make the

Japanese financial industry as a whole more competitive, and are directed to securities firms and insurance

companies as well as to banks. They create a different

competitive structure, authorizing financial holding

companies, heretofore banned in Japan, and eliminating most of the restricted powers enjoyed by the different kinds of financial firms. They allow for

broad­based competition and even permit foreign entities to enter the Japanese market. The reforms eliminate the distinctions between the different kinds of

banks, allowing them to compete in one another's territory. They also eliminate a bank monopoly-foreign

exchange-but permit banks to enter other, potentially lucrative financial areas, such as mutual fund distribution, underwriting and trading of securities, asset

management, and eventually, perhaps, insurance sales

(not yet decided). The Big Bang proposals also promote increased transparency and Western standards of

governance. A new agency, the Financial Supervisory

Agency (FSA), reporting directly to the prime minister

and independent of the MOF, has been created to

assume supervisory control over the financial entities

currently supervised by the MOF. 

Increased competition and greater transparency,

goals of the Big Bang financial industry reforms, have

much more potential to change the economic outlook

for Japanese banking than cash infusions or other shortterm government fixes. However, many of the Big

Bang reforms have been put on hold while the government deals with the immediacy of the banking crisis.

And unfortunately it is not at all clear that either the

financial industry or the still powerful MOF is fully

committed to the idea of unfettered competition. The

verdict on the Big Bang financial reform proposals is

therefore still out. The Big Bang reforms, and the

opportunities and problems they present, will be the

subject of a subsequent article in the FDIC Banking

Review.

28"Japan's Bailout Fund Won't Squeeze Banks," The Wall Street

Journal (February 27, 1998), A13.

17
FDIC Banking Review

Recent Developments
 

Affecting Depository
 

Institutions
 

by Lynne Montgomery*

REGULATORY AGENCY ACTIONS
 

Inter-Agency Actions

Bank Examiners Adopt New Risk-Based

Procedures

On October 1, 1997, the Federal Reserve Board,

the FDIC, and state banking departments began

implementing a common risk­focused examination

procedure for state­chartered community banks.

The new process channels examiners' attention

toward those activities posing the highest level of

risk at each bank and aims to improve bank examiners' ability to diagnose emerging problems. The

Federal Reserve Board (FRB) and the FDIC developed exam procedure modules to help examiners

analyze community banks' most important activities,

including loan portfolio management, securities,

management and internal controls, earnings, and capital. 

In order to simplify examinations further, federal

and state examiners are using a new software program called "ELVIS" (Examiner Laptop Visual

Information System). Examiners may use the program to organize notes and store agency rules, which

reduces the burden of documentation and paperwork

and gives examiners more time to analyze a bank's

operations. AB, 10/2/97; BBR, 10/6/97, pp. 527-528.

Simplified Market Risk Rules

On December 9, 1997, the FDIC approved an

interim final rule allowing banks under its supervision to calculate specific market risks with internal

valuation models, eliminating the requirement to

compare the model­generated results with those of

the standardized measure developed by the international Basle Committee on Banking Supervision.

The rule reduces regulatory burden by no longer

requiring institutions to develop and maintain two

separate methods for measuring market risk exposure to specific stock and bond positions in their trading portfolios. The rule applies only to those

institutions whose trading portfolio represents 10

percent or more of their assets, or whose trading

activities amount to $1 billion or more.

The rule was approved on an inter­agency basis,

with the FRB issuing an interim rule on December

19, and the OCC on December 23, 1997. The three

agencies together supervise fewer than 20 institutions that would be affected by the market risk rule.

PR-92-97, FDIC, 12/9/97; BBR, 12/15/97, p. 868.; NR 97-115, aCC,

12/23/97. 

Less-Frequent Exams for Healthy Banks

and Thrifts

The four federal banking and thrift regulatory

agencies issued a final interim rule on April 2, 1998,

that permits less­frequent examinations for small,

well­run thrifts and banks. The rule shifts the exam

cycle for eligible institutions from every 12 months to

*Lynne Montgomery is a financial analyst in the FDIC's Division of

Research and Statistics.

Reference sources: American Banker (AB); The Wall Street Journal (WSJ);

BNA's Banking Report (BBR); and Federal Register (FR).

18
Recent Developments

every 18 months. Eligible institutions must have no

more than $250 million in assets, be rated CAMELS

1 or 2, be well­capitalized and well­managed. A

longer exam cycle permits the agencies to focus their

resources on institutions that present the most immediate supervisory concerns and reduces regulatory

burden on smaller, well­run institutions. aTS 98-25,

4/2/98.

Common Merger Application

The four federal regulatory agencies for banks and

thrifts proposed a uniform application for institutions

to use for mergers, consolidations, and combinations.

Financial institutions would no longer be required to

submit different forms to each agency. The action is

part of the agencies' continuing review of corporate

forms to simplify procedures, eliminate duplicative

or outdated policies, and otherwise reduce burdens

for financial institutions. NR 98-7, aCC, 1/21/98.

HMDA Data Collection Rules

Beginning January 1, 1998, depository institutions

with assets totaling $29 million or less will be

exempted from collecting data on mortgage loan

originations. The Home Mortgage Disclosure Act

(HMDA) requires lenders above a certain size to collect data on the loans they originate and file reports

of that data with federal regulators. The Economic

Growth and Regulatory Paperwork Reduction Act of

1996 provided that the asset exemption level be tied

to increases in the Consumer Price Index. In January

1997, the FRB issued an interim rule raising the asset

exemption level from $10 million to $28 million in

order to bring the requirement up to date with the

1996 index. During the twelve­month period ending

in November 1997, the price index rose 2.4 percent,

resulting in a new exemption threshold of $29 million in assets. The new level will be in effect

throughout 1998. BBR, 12/22/97, p. 906.

No Banking Holiday for Year 2000

The FRB announced that banks would remain

open for normal operations on December 31, 1999.

Various financial and trade groups have suggested

that a banking holiday on December 31, 1999 would

give the banks more time to deal with potential computer­related disruptions caused by the century date

change. However, the FRB believes that bank

resources will be better spent "preparing for the year

2000 change­over rather than addressing the operating, financial, legal and other consequences that

would flow from a date­change holiday." BBR, 2/2/98, p.

165.

Expanded Year 2000 Authority

On March 20, 1998, President Clinton signed legislation giving the Office of Thrift Supervision and

the National Credit Union Administration additional

authority to address Year 2000 computer­related

problems. The "Examination Parity and Year 2000

Readiness for Financial Institutions Act" would give

the thrift and credit union regulatory agencies the

same supervisory authority over third­party software

vendors that banking regulators already have. The

new law further requires that financial regulatory

agencies offer seminars to the institutions they regulate on the safety­and­soundness implications of the

Year 2000 problem and offer model approaches for

solving common Year 2000 problems. The law puts

the regulatory authority of credit unions and thrifts

on par with that of other financial regulators. BBR, 3/30/98. 

Federal Deposit Insurance Corporation

Tanoue Nominated to Head FDIC

On November 7, 1997, President Clinton nominated Honolulu banking attorney Donna Tanoue to

head the FDIC. Ms. Tanoue will replace Acting

FDIC Chairman Andrew C. Hove Jr., who took the

post in June 1997, after the resignation of former

Chairman, Ricki Helfer. Ms. Tanoue is currently a

partner with the law firm of Goodsill, Anderson,

Quinn & Stifel. Her practice has focused on banking

and real­estate finance, with emphasis on bank regulatory matters. Formerly, she served as Commissioner of Financial Institutions for the state of

Hawaii, and she is credited with restoring financial

stability to Hawaii's thrift and industrial loan company industry. BBR, 11/17/97, p. 738.

Semiannual Agenda of Regulations

The FDIC published its semiannual regulatory

agenda in the Federal Register on October 29, 1997.

The agenda provides information about the FDIC's

projected new rule makings, as well as existing regulations under review and completed rule makings.

Many of the actions are the result of the FDIC

Board's ongoing efforts to reduce the regulatory burden on banks, simplify rules, improve efficiency and

comply with the Riegle Community Development

and Regulatory Improvement Act of 1994. The

agenda contains 31 regulatory actions. Seven actions

19
Recent Developments

have been completed and the remaining actions are

in various stages of the rule­making process. PR-79-97,

FDIC, 10/30/97.

Assessment Rates

On November 12, 1997, the FDIC Board of

Directors voted to leave deposit insurance premium

rates unchanged through the first half of 1998. The

current risk­related assessment rates range from zero

basis points to 27 basis points for both BIF­insured

and SAIF­insured institutions. The FDIC reported

that more than 95 percent of BIF­insured institutions

and more than 90 percent of SAIF­insured institutions are rated well­capitalized and will continue to

pay nothing for their deposit insurance coverage.

The rate schedule is expected to maintain both the

BIF and SAIF reserve ratios above the Congressionally mandated 1.25 percent (reserves as a

percent of insured deposits). As of June 30, 1997, the

BIF ratio was 1.35 percent and the SAIF ratio was

1.32 percent. PR-82-97, FDIC, 11/12/97.

Bank Failure

The FDIC announced the first bank failure in

more than a year. On November 21, 1997, the

Louisiana Commissioner of Financial Institutions

closed Southwest Bank, Jennings, La., and named

the FDIC as receiver. The FDIC approved the

assumption of Southwest Bank's deposits by newly

chartered First Southwest Bank, also of Jennings.

First Southwest Bank opened its doors on November

24, 1997. The FDIC estimated the cost to the Bank

Insurance Fund to be approximately $3.5 million.

The Southwest Bank failure is the first BIF­insured

institution to fail since August 1996 and the first bank

in Louisiana to fail since November 1992. PR-84-97,

FDIC, 11/21/97.

External Auditing Procedures

Effective December 31, 1997, the FDIC rescinded an obsolete policy statement that provides guidance on external auditing programs for

state­chartered banks that are not members of the

Federal Reserve System. The policy statement recommended that all FDIC­supervised banks have

their financial statements reviewed by a certified

public accountant as part of their external auditing

programs. The policy also provided two alternatives

for an institution whose board of directors or audit

committee determined that a financial statement

audit was inappropriate for their external auditing

program. However, the FDIC has determined that

the two alternatives are no longer acceptable substitutes for an audit and has offered two new alternatives. The new alternatives consist of a report on the

institution's balance sheet, or documentation of adequate internal controls on certain parts of its regulatory reports, both of which should be performed by

an independent accountant. BBR, 1/12/98, pp. 46-47.

1997 Financial Results

The Bank Insurance Fund (BIF) earned $1.4 billion in 1997, ending the year with a record fund balance of $28.3 billion. The Savings Association

Insurance Fund (SAIF) earned net income of $0.5

billion for the year and ended the year with a record

balance of $9.4 billion. The continuing low numbers

of bank and thrift failures contributed to the strong

results. Only one BIF­insured institution failed during the year. No SAIF­insured institution failed in

1997. Revenue for the BIF totaled $1.6 billion for

the year. The fund earned $1.5 billion in interest on

investments in U.S. Treasury securities and received

another $25 million in deposit insurance assessments.

The SAIF received $550 million in revenue, consisting of $535 million in interest on investments in U.S.

Treasury securities and $14 million in deposit insurance assessments.

The FSLIC Resolution Fund (FRF) assets in liquidation were reduced by 51 percent over the year to

a balance of $2.4 billion at year­end. Federal

Financing Bank borrowings for the FRF were

reduced by $3.7 billion to $0.8 billion. PR-20-98, FDIC,

3/24/98.

Real-Estate Survey - October 1997

The October 1997 issue of the Survey of Real Estate

Trends reported continuing positive views of local

commercial and residential real­estate markets. The

survey polled 311 senior examiners and asset managers at the federal bank and thrift regulatory agencies. More than half of those responding to the

survey (54 percent) reported improved commercial

market conditions for the three months ending in

October, compared to only 46 percent of those participating in October 1996. Forty­two percent of the

participants reported that residential real­estate market conditions were better than three months earlier,

compared to 35 percent in October 1996.

The national composite index used by the FDIC

to summarize results for both residential and commercial real­estate markets was 71 in October, which

is down from 74 in July but up from 67 in October

20
Recent Developments

1996. The national index for commercial markets of

77 in October was essentially unchanged from July.

The commercial index increased for all regions

except the South. In contrast, the residential composite index fell in all four regions. The national residential index was 67 in October, down from 73 in

July. Index values above 50 reflect improving conditions, while values below 50 indicate declining conditions. Survey of Real Estate Trends, FDIC, actober 1997.

Real-Estate Survey - January 1998

The January 1998 issue of the Survey of Real Estate

Trends reported that conditions in residential and

commercial real­estate markets continued to be

favorable. Forty­nine percent of those surveyed

described local housing market conditions as improving, compared with 42 percent in October. Strong

home sales and a tight housing supply contributed to

the favorable observations of housing market conditions. The percentage of participants noting better

conditions in local commercial markets dropped to 49

from a record high of 54 in October.

The national composite index increased from 71 in

October to 72 in January. Regionally, the respondents reported an increasingly tight housing market

in the West, rising sale prices for existing homes in

the Northeast, above­average volume of apartment

construction in the Midwest, and increasing sales of

commercial properties in the South. The survey

polled 298 examiners and assets managers from the

federal bank and thrift regulatory agencies. Survey of

Real Estate Trends, FDIC, January 1998.

Report on Underwriting Practices

The October 1997 issue of the Report on

Underwriting Practices reported that banks' underwriting standards showed no widespread problems,

but indicated that lending for both commercial real

estate and construction should be monitored more

carefully in the future. Compared to the previous

report issued in May 1997, more institutions active

in commercial real­estate and construction lending

made higher­risk loans. Implemented in early 1995,

the survey of underwriting practices is aimed at providing early warnings of potential problems in

underwriting practices at FDIC­supervised, statechartered nonmember banks. The focus of the survey is threefold: material changes in underwriting

standards for new loans, degree of risk in current

practices, and specific aspects of the underwriting

standards for new loans. Slightly more than 90 percent of the banks examined in the six­month period

ending September 30, 1997 showed no material

change in overall underwriting practices since their

last examination. Report on Underwriting Practices, FDIC, actober

1997.

Foreign Banking Activities

On March 24, 1998, the FDIC Board of Directors

announced a new regulation that dramatically

reduces filing requirements for most banks when

they want to open a foreign branch or make a foreign

investment. In addition, the regulation permits wellrun, well­capitalized institutions with no pending

enforcement actions to initiate new activities abroad

without prior Board approval. The institutions are

required to notify the FDIC after new operations

begin. The new regulation also streamlines the

FDIC's internal application processing procedures,

which will expedite decisions on application

requests. PR-19-98, FDIC, 3/24/98.

Deposit Interest Payments

The FDIC Board of Directors approved a final

rule on February 10, 1998, making its exceptions to

the statutory ban on demand deposit interest payments track those issued by the FRB. Under the

final rule, the FRB's exceptions to the statutory ban

on paying interest on certain demand deposits would

automatically apply to all FDIC­supervised institutions. Before the rule, federal law required the FDIC

to issue similar exceptions to the general prohibition

on demand deposit interest payments that the FRB

authorized for the institutions it supervises.

However, occasionally the FRB issued a specific

exception to the ban before the FDIC could implement a similar action, which put the FDIC­supervised institutions at a temporary competitive

disadvantage relative to FRB­supervised institutions.

BBR, 2/16/98.

Federal Reserve Board

Risk-Based Approach to Consumer
 

Compliance Reviews
 

On September 25, 1997, the Federal Reserve

Board announced a new risk­based consumer compliance supervision program and extended the consumer compliance exam cycle for state member

banks and foreign banking companies. The program,

which will be phased­in throughout 1998, focuses on

the relationship between "regulation risk" and

"product risk" to determine the likelihood of an

institution complying with consumer protection

21
FDIC Banking Review

rules. The relationship between the two risk elements will be correlated to determine the appropriate level of oversight for an institution.

The program also extends the frequency of consumer exams for well­managed state member banks

with excellent compliance histories. State member

banks with less than $250 million in assets and two

"satisfactory" or better ratings for compliance with

consumer protection rules and the Community

Reinvestment Act would be examined every 36

months, instead of every 18-24 months. Banks with

more than $250 million in assets and excellent compliance records will be evaluated every 24 months,

and banks with consumer compliance problems will

be examined annually. BBR, 10/6/97, p 528.

Regulation Z

The Federal Reserve Board announced final revisions to its Regulation Z, the Truth in Lending Act

Regulation. The revisions would allow lenders to

provide borrowers with simplified disclosures for

variable­rate loan payments. The final rule applies to

any adjustable­rate loan with maturity greater than

one year that is secured by the borrower's principal

residence. The rule became effective on November

21, 1997, with compliance optional until December

22, 1997. BBR, 12/1/97, p. 806.

Regulation U

Beginning April 1, 1998, the FRB will permit

banks to lend up to 100 percent of the purchase price

of "small cap" stocks listed by NASDAQ. Under

Regulation U, the banks were not permitted to lend

more than 50 percent of the purchase price of these

securities. The FRB also gave banks permission to

lend up to half the purchase price of exchange­traded options. Before this decision, banks were not permitted to lend any portion of the purchase price of

these securities. A federal law continues to prevent

banks from financing more than half the purchase

prices of issues traded on major exchanges, such as

the New York Stock Exchange or the other securities

listed by NASDAQ. AB, 12/19/97.

New Policy on Cash Processing

Under a revised Federal Reserve Board policy

statement published in the Federal Register on March

10, 1998, depository institutions will have more flexibility to obtain cash services from district Federal

Reserve Bank offices. The statement allows banks

to designate ten "end­points" to receive cash from a

Federal Reserve Bank office. An "end­point" is

defined as a branch, head office, money room, or

armored car used by the depository institution to

handle cash orders and deposits. Previously, the

FRB required banks to access the cash processing

system from sites within their home Federal Reserve

Bank district. The revised policy provides flexibility

to depository institutions to make the most costeffective arrangements for obtaining cash services

from Reserve Bank offices. AB, 3/10/98; BBR, 3/16/98, p. 429.

Office of the Comptroller of the Currency

Ludwig Resigns

After five years as Comptroller of the Currency,

Eugene A. Ludwig resigned at the end of his term on

April 4, 1998. He plans to return to the private sector and to spend more time with his family. BBR,

1/26/98, p. 121.

Acting Comptroller

Effective April 5, 1998, Julie L. Williams became

acting Comptroller of the Currency. Ms. Williams

had been Chief Counsel since 1994 and was also designated First Deputy Comptroller. Under the

National Bank Act, she automatically became acting

Comptroller following Mr. Ludwig's departure. NR

98-37, aCC, 4/6/98.

Asset Securitization Handbook Issued

The OCC released its first handbook on asset

securitization on November 12, 1997, entitled

Comptroller's Handbook: Asset Securitization. The OCC

acknowledged that the loans most often consolidated

for securitization are consumer loans but anticipates

that non­consumer assets will be next. The handbook is aimed at giving bank officials a better understanding of the benefits and risks associated with

securitization and outlines procedures for effective

risk management. The booklet also focuses on a

bank's use of asset securitization to manage its balance sheet and generate fee income. NR 97-101, aCC,

11/12/97; BBR, 11/17/97, p. 758.

New Assessment Schedule

On December 3, 1997, the OCC released a new

schedule of fees and assessments that means extra

costs for national banks and other OCC­regulated

institutions that receive lower supervisory ratings.

For each national bank or OCC­regulated foreign

firm, the OCC imposes a semiannual assessment

22
Recent Developments

based on a formula set out in 12 CFR 8.2; however,

the formula did not reflect the extra costs involved in

supervising banks that need special attention. The

new rule imposes a surcharge equal to 25 percent of

their assessment on banks scoring 3, 4, or 5 under the

CAMELS rating system. Foreign branches or agencies of foreign banks that receive ROCA ratings of 3,

4, or 5 will also pay a 25 percent surcharge. The

ROCA rating ranks risk management, operational

controls, compliance, and asset quality. In addition,

the assessments for nonlead national banks in multibank holding companies were lowered by 12 percent.

The OCC also dropped the annual franchise fee that

had been imposed on national banks that are registered as municipal or government securities dealers.

The final rule took effect on December 31, 1997. NR

97-106, aCC, 12/3/97; BBR, 12/8/97, p. 836.

Survey of Credit Underwriting 

Practices
 

The 1997 Survey of Credit Underwriting Practices

found that strong competition among financial institutions is driving national banks to continue easing

credit standards for most types of commercial loans.

The survey evaluated the lending practices at 80 of

the largest national banks and compared the results

to the 1996 survey. Almost 60 percent of the banks

participating in the survey eased lending standards

for one or more types of commercial loans. The survey reported weaker underwriting standards for

home­equity and residential real­estate loans; however, loan requirements were tighter for small­business and agricultural loans. The survey also noted

that credit requirements were stricter for credit cards,

consumer loans, and affordable housing lending.

The aggregate loan portfolio of the banks surveyed

was approximately $1.5 trillion, which represents

approximately 84 percent of all outstanding loans in

national banks as of June 30, 1997. NR 97-112, aCC,

12/16/97; BBR, 12/22/97, p. 901.

National Banks to Sell Crop Insurance 

The OCC's General Counsel stated that the

National Bank Act permits national banks to offer

crop insurance in connection with loans they make to

farm customers. Crop insurance is intended to protect farmers' loss of income because of crop failure or

low yields, and to reduce lenders' exposure to agricultural credit risk. The 1996 farm bill repealed federal farm price guarantees on many crops, which has

increased banks' risk of farmers defaulting on agricultural loans. As a result, many farmers have

become interested in national banks providing crop

insurance coverage. State­chartered banks in Iowa

have been selling crop insurance to farm customers

for years through licensed agents employed by the

banks. The General Counsel wrote that crop insurance enhances or facilitates a bank's lending activity

by protecting the bank's loans, and is therefore part

of a bank's lending operations. BBR, 1/5/98, p. 14.

Year 2000 Preparations Factor in
 

Applications
 

In an advisory letter released on January 23, 1998,

the OCC said that national banks' preparations for

the Year 2000 computer problem would be a factor

when reviewing certain applications. The applications addressed in the letter include new charters,

mergers, conversions, and new federal branches of

foreign banks. Applications for certain operating

subsidiaries are also affected, and applicants will

have to make sure that their vendors are Year 2000­

compliant. NR 98-8, aCC, 1/23/98; BBR, 2/2/98, p. 165.

Bank Underwrites Municipal Bonds

A barrier between commercial and investment

banking was broken on December 11, 1997, when

the OCC gave permission to a national bank to

underwrite municipal revenue bonds. Zions First

National Bank of Salt Lake City, Utah, is permitted

to form an operating subsidiary to issue the bonds.

The Glass­Steagall Act prohibits banks from underwriting securities or owning stock in corporations that

are "principally engaged" in securities underwriting;

however, the Act makes no mention of firms that

earn only a portion of their revenue by underwriting

securities. The OCC claims that this omission

enables banks to own firms involved in underwriting.

AB, 12/12/97, 1/7/98.

Bank Offers Digital Signature 

Products
 

The OCC has conditionally approved an application for Zions First National Bank to be the first

financial institution to offer digital signature products

to its customers. Digital signatures are used for electronic authentication of the sender of an electronic

message and can provide an important way for consumers and businesses to decide which electronic

communications they can trust. The approval permits Zions to establish an operating subsidiary to act

as a certification authority to enable subscribers to

23
FDIC Banking Review

generate digital signatures that verify the identity of

a sender of an electronic message. The certification

process will also enable subscribers to be certain that

communications received have not been altered during transmission. The bank plans to focus on certification services primarily involving corporate and

government contracts. NR 98-4, aCC, 1/13/98.

Office of Thrift Supervision

Seidman Named Director

On October 29, 1997, Ellen S. Seidman was sworn

into office to a five­year term as Director of the OTS.

She takes over the agency from Nicolas Retsinas,

who became Director in October 1996 while remaining Assistant Secretary and Federal Housing

Commissioner at the Department of Housing and

Urban Development. 

Ms. Seidman spent the past four and one­half

years as special assistant to President Clinton for

economic policy at the White House National

Economic Council. During her time at the

Economic Council, she was chairwoman of the interagency working group on pensions and has been

responsible for issues such as financial institutions,

natural disaster insurance, bankruptcy, and home

ownership. Before joining the Administration, she

was Senior Vice President for Regulation, Research,

and Economics at Fannie Mae. aTS 97-78, 10/28/97; BBR,

11/3/97, p. 688.

Court Rules for Thrift Acquirers

On December 22, 1997, the U.S. Court of Federal

Claims ruled in favor of the acquirers of several troubled thrifts on contract claims against the federal government. The acquirers claimed that the

government breached existing contracts when it

changed the accounting and regulatory treatment of

supervisory goodwill through the enactment of the

Financial Institutions Reform, Recovery, and

Enforcement Act (FIRREA) in 1989. The acquirers

claimed that the favorable accounting and regulatory

treatment promised by the government was key to

their acquisitions when they acquired the thrifts earlier in the 1980s. There are more than 120 pending

cases brought by acquirers of troubled thrifts. BBR,

1/5/98, p. 29.

Electronic �uidelines Urge Internal
 

Controls
 

On October 15, 1997, the OTS issued examination

guidelines that focus heavily on an institution's internal policies and controls for Internet banking and

other electronic services. The guidelines emphasize

that thrifts should adopt risk­management programs

to monitor threats posed by electronic banking. OTS

examiners are instructed to conduct a brief initial test

that primarily determines whether a thrift has proper

auditing procedures to monitor its technologies. If

the initial review raises concerns, examiners will use

more­detailed checks in up to seven areas, including

strategic planning, operating controls, business insurance coverage, and information security. AB, 10/17/97.

Intermediate Holding Companies

Effective April 1, 1998, the OTS will allow mutual holding companies to set up a stock holding company as an intermediate subsidiary. The stock

holding company will be sandwiched between the

mutual holding company and its savings association

in a three­level corporate structure. The controlling

interest in the subsidiary holding company resides

with the parent mutual holding company. The OTS

said the rule provides mutual holding companies

with increased flexibility to establish corporate structures that can take advantage of market opportunities

while protecting the rights of mutual depositors.

TR-192, aTS, 3/9/98; BBR, 3/16/98, p. 446.

Lower Liquidity Requirement

On November 24, 1997, the OTS lowered the liquidity requirement for savings associations from 5 to

4 percent of the institution's liquidity base. The new

final rule also requires that each savings association

maintain sufficient liquidity to ensure its safe­andsound operation. The final liquidity rule increases

regulatory flexibility and is part of the OTS's ongoing

effort to simplify its regulations and reduce regulatory burden. aTS 97-82, 11/24/97.

Capital Distributions

The OTS proposed a rule on January 7, 1998, that

would allow well­run, healthy savings associations to

pay cash dividends without notifying their federal

regulator. The institutions would have to satisfy

specified criteria in order to qualify. The proposed

rule change would bring the OTS's capital distribution regulations into greater conformity with those of

the other federal banking regulators and reflects the

improved capital position of the thrift industry. aTS

98-1, 1/7/98.

24
Recent Developments

National Credit Union Administration

Supreme Court Rejects NCUA Policy but

House Brings Relief

On February 25, 1998, the U.S. Supreme Court

ruled against the National Credit Union

Administration, stating that it misread the Federal

Credit Union Act when it eased membership standards for a class of federal credit unions. The case

centered on Section 109 of the Federal Credit Union

Act, which requires members of each credit union to

share a "common bond." Since 1982 the NCUA has

argued that federal occupation­based credit unions

meet the "common bond" requirements even if multiple occupations are represented, and the NCUA

allowed credit unions to expand their membership

dramatically. The American Bankers Association and

several banks sued the NCUA, charging that the

statute limits each credit union to one employee

group, all of whose members share a single common

occupational bond. The Court agreed with the

bankers in an opinion by Justice Clarence Thomas.

However, on March 26, 1998, the House Banking

Committee approved a bill that gives credit unions

relief from the Supreme Court ruling. The bill,

called the Credit Union Membership Access Act, was

also approved by the House of Representatives on

April 1, 1998. BBR, 3/2/98, p. 333; BBR 3/30/98; AB, 4/2/98.

NCUA Approves Chartering Change

The National Credit Union Administration's

Board of Directors voted on January 22, 1998, to

adopt an amendment to its rules to make it easier for

a credit union to convert to a community­based charter. The Board agreed to remove the current requirement that credit unions wishing to convert to

community charters must provide evidence of community support. BBR, 1/26/98, p. 141.

New Risk Rating System for 

Corporates
 

The National Credit Union Administration is testing a new risk rating system for corporate credit

unions. The new system, the Corporate Credit

Union Risk Rating System (CCURRS), is expected

to replace the current system, CAMELS, by May 1,

1998. Corporate credit unions provide investment,

payment, liquidity, and support services to naturalperson credit unions. The NCUA said the new system was designed to recognize that corporate credit

unions are unique and "the combination of financial

and operational risks managed by corporates differ

significantly from the risks incurred by commercial

banks, thrifts, and natural­person credit unions."

BBR, 2/2/98, p. 188.

Securities and Exchange Commission

Year 2000 Costs Disclosed

The Securities and Exchange Commission issued

guidelines on January 12, 1998, requiring that publicly traded banks disclose what they expect to spend

rectifying possible Year­2000 computer problems.

The institutions are also required to outline their

general plans for addressing the computer problems

in their financial statements and provide a timetable

for carrying them out. AB, 1/13/98.

Federal Housing Finance Board

FHLBanks to Meet SEC Disclosure
 

Standards
 

The Federal Housing Finance Board proposed a

rule that would require Federal Home Loan Banks to

comply with SEC quarterly and annual reporting

rules. Certain securities issued by the Finance Board

and the FHLBanks are exempt from registration and

reporting requirements of the Securities Exchange

Act of 1934 and are treated as government securities.

Under the Finance Board's proposed rule,

FHLBanks would be required to submit unaudited

quarterly financial statements, as well as audited

annual financial reports, to the Board and FHLBank

members. The reports would be prepared in accordance with the SEC's financial disclosure and

accounting requirements. Currently, all of the

FHLBanks submit annual financial statements, but

not all of them issue quarterly financial reports. BBR,

1/26/98, p. 141.

FHLBanks Continue to Borrow

The Federal Housing Finance Board voted unanimously to allow the Federal Home Loan Bank

System's Office of Finance to continue to borrow

without limit through the rest of 1998. In late 1997,

25
FDIC Banking Review

the Finance Board decreed that the Office of

Finance's debt­issuance authority would expire at

the end of March. The Board lifted the constraint as

it prepares to address underlying policy issues relating to the System's finances. The FHLB System has

come under criticism for pursuing aggressive borrowand­invest practices at the expense of its traditional

mission of making low­cost loans, called advances, to

mortgage­lending institutions. The Wall Street Journal,

3/16/98.

OTHER ENTITIES
 

Financial Accounting Standards Board

Derivatives Rule Delayed

The Financial Accounting Standards Board voted

to delay by six months the effective date of its new

derivatives rule. The new derivatives rule, which

will become effective June 15, 1999, will require

companies to report derivatives at fair market value

on quarterly income statements. Bankers and regulators have argued that the cost of compliance, coupled with the Year 2000 expenses, would be

extremely burdensome. AB, 12/18/97.

Federal Financial Institutions

Examination Council

Year 2000 �uidance

The FFIEC issued additional guidance for financial institutions on risks they face because of the Year

2000 date change. The inter­agency statements,

"Guidance Concerning Institution Due Diligence in

Connection with Service Provider and Software

Vendor Year 2000 Readiness" and "Guidance

Concerning the Year 2000 Impact on Customers"

supplement the statement issued on May 5, 1997.

The guidance clarifies the importance of developing

and executing a due­diligence process for each mission­critical service and product supplied by service

providers or software vendors. This process should

enable an institution's management to identify the

obligations of the institution and its service providers

and software vendors. The institution should also

establish an effective monitoring program of the renovation phase, establish a process for testing the renovated products and services, and adopt contingency

plans in the event of information systems disruptions. The statements also provide guidance that

should enable a financial institution's management to

effectively assess the Year 2000 readiness of the institution's borrowers, fund providers, and asset management. FIL-29-98, FDIC, 3/18/98.

STATE LEGISLATION AND REGULATION
 

Texas

On January 1, 1998, a constitutional amendment

was passed that permits home­equity lending in

Texas. This amendment ends a 123­year­old prohibition on home­equity lending in Texas. The

amendment permits homeowners to borrow up to 80

percent of the market value of a home. BBR, 11/10/97, p.

712.

Florida

On February 27, 1998, Florida regulators imposed

a 90­day moratorium on conversions of credit unions

from federal to state charters in order to prevent a

flood of applications resulting from the February 25,

1998, U.S. Supreme Court ruling that credit unions

must be composed of only one employer group. BBR,

3/9/98, p. 400.

Iowa

With Congress threatening to abolish the thrift

charter, savings and loans in Iowa are urging lawmakers to create a new state savings bank charter. If the

plan were enacted, Iowa's 30 thrifts could convert to

the new charter and retain liberal branching rights.

Iowa forbids commercial banks from branching into

communities where another bank already operates.

Commercial banks could also use the new charter to

better compete with brokerage firms, credit unions,

and other financial­services companies. AB, 2/10/98.

BANK AND THRIFT PERFORMANCE
 

Third-Quarter 1997 Results for
 

Commercial Banks and Savings
 

Institutions
 

Commercial banks continued to produce record

earnings, reporting net income of $14.8 billion for the

third quarter of 1997. Third­quarter earnings were

$131 million more than the previous earnings record

set in the second quarter. This also marks the third

consecutive quarter that earnings reached an all­time

high. The increase in earnings this quarter was sup26
Recent Developments

ported by stronger financial performance of creditcard specialty banks, and by higher trading profits at

a few large banks. In the second quarter, restructuring charges and the expense of boosting reserves at

some large credit­card banks caused profits for that

group of institutions to dip sharply. Profits of this

group more than doubled in the third quarter to $1.3

billion. The third­quarter annualized return on

assets was 1.22 percent, down slightly from the second quarter ROA of 1.24 percent, but above the 1.19

percent of a year ago. For the fourth consecutive

quarter, no insured commercial banks failed. The

number of problem banks decreased from 74 in the

second quarter to 71 at the end of the third quarter.

The problem banks have total assets of approximately $5 billion.

FDIC­insured savings institutions reported earnings of $2 billion in the third quarter of 1997, for an

annualized ROA of 0.79 percent. Earnings declined

from the second quarter by $398 million, primarily

because of charges related to acquisitions. The savings industry earned $6.6 billion in the first three

quarters of 1997, up by $1.7 billion over the same

period in 1996, and within $1 billion of the annual

record set in 1995. Ninety percent of all savings

institutions showed improved quarterly earnings

from a year ago. The number of problem institutions

declined to 27, compared to 29 in the second quarter.

Assets of problem institutions declined to $2 billion

at the end of the third quarter from $2.8 billion in the

second quarter. FDIC Quarterly Banking Profile, Third Quarter 1997.

Fourth-Quarter 1997 Results for

Commercial Banks and Savings

Institutions

Insured commercial banks had record earnings in

the fourth quarter of 1997, as well as for the full year.

Fourth­quarter net income totaled $15.3 billion, an

increase of $511 million from the third quarter. For

all of 1997, banks posted record net income of $59.2

billion, up $6.9 billion from 1996 annual results. The

FDIC attributes the higher bank earnings in 1997 to

increased net interest income and higher noninterest

income. The fourth­quarter annualized return on

assets rose to 1.24 percent, up from 1.22 percent in

the third quarter of 1997 and 1.21 percent in the

fourth quarter of 1996. For the full year, commercial

banks' ROA was 1.23 percent, the highest annual

rate recorded by the industry since the FDIC was

established. One insured commercial bank failed

during the fourth quarter, which was the first bank

failure in 15 months.

FDIC­insured savings institutions reported net

income of $2.4 billion in the fourth quarter, an

increase of $197 million from the fourth quarter of

1996. Total earnings for the year were a record $8.8

billion, which is $1.8 billion higher than in 1996. The

main reasons for the record earnings were lower noninterest expenses, a decline in provisions for future

loan losses, and increased profits from sales of securities. Savings institutions had an annualized ROA of

.95 percent in the fourth quarter and posted an ROA

of .93 percent for the year. There were no federally

insured savings institution failures in 1997, which is

the first year of no failures since 1959. PR-14-98, 3/12/98.

RECENT ARTICLES AND STUDIES
 

The Treasury Department released a study on

November 17, 1997, entitled American Finance for the

21st Century. The study finds that financial marketplace failures, even very large ones, are inevitable;

and therefore, federal regulators should adopt a policy of containment that isolates individual upsets

while protecting the financial system as a whole.

Congress directed the Treasury to perform the study

in the Riegle­Neal Interstate Banking and Branching

Efficiency Act of 1994. The report was written by

Robert E. Litan, director of the Economic Studies

Program at the Brookings Institution, and Jonathan

Rauch, a contributing editor of the National Journal.

BBR, 11/24/97, pp. 778-79.

On December 11, 1997, the House Banking

Committee released a report entitled U.S. Financial

Services Sector Vulnerable to Computer Attack, which

claims that the U.S. financial­services sector is not

addressing security problems fast enough to keep up

with the rapid growth of the Internet. The report

addresses the vulnerability of the financial­services

sector to foreign and domestic computer crime and

estimates that financial firms may be losing $2.4 billion a year because of theft by computer. The reasons stated for the vulnerability are that computer

software is outdated, telecommunications systems

are easy to access globally, and computer hackers can

decipher encryption codes. BBR, 12/15/97, p. 881.

A similar study released on December 18, 1997, by

the FDIC reported that financial institutions must

27
FDIC Banking Review

recognize the security risks associated with the

Internet and implement appropriate measures to protect their systems and data from unauthorized access.

The paper, entitled Security Risks Associated with the

Internet, identifies risks posed by using the Internet

as an information resource or service delivery tool.

The paper is intended to supplement the FDIC

Division of Supervision's existing supervisory procedures for electronic banking activities, and to provide

bank managers with information to help identify

potential risk factors and security solutions.

FIL-131-97, 12/18/98; BBR, 1/5/98, p. 9.

The Treasury Department released a study on

December 11, 1997, entitled Credit Unions, which

was mandated by the Economic Growth and

Regulatory Paperwork Reduction Act of 1996. The

report concludes that credit unions are safe­andsound institutions. The study also concludes that the

credit union insurance fund is well­capitalized, has

had few losses over recent years, and appears to be

able to handle financial crises in the credit union

industry. The study did recommend that credit

union regulators adopt supervisory policies for market risk similar to those employed by bank regulators, including capital requirements, market­risk

measurements, and prompt corrective action provisions for troubled credit unions. BBR, 12/15/97, pp. 885-86.

The FDIC has published a study entitled History

of the Eighties-Lessons for the Future, which presents

a comprehensive analysis of the banking crises of the

1980s and early 1990s. The two­volume study also

evaluates the lessons learned from the crises. In the

first volume, the FDIC presents its assessment of the

economic, structural, supervisory and legislative conditions present as the era of failures began. The

FDIC also reviews how these factors changed over

time, as well as the policy implications for future

banking problems. The second volume contains the

proceedings of the History of the Eighties symposium held by the FDIC in 1997. PR-1-98, FDIC, 1/8/98.

The Consumer Bankers Association's annual

Consumer Credit Collections Study reported that bankruptcies account for 40 percent of all credit­card losses at large banks. The study, released on January 16,

1998, also reported that the credit­card bankruptcy

charge­off rate at smaller institutions was 27 percent.

BBR, 1/26/98, p. 130.

A Georgetown University study entitled Credit

Union Insurance and Regulation concludes that the

government should maintain a separate insurance

fund for credit union deposits. The study finds that

credit unions are better capitalized than banks, and

the credit union fund performed much better than

the other funds during the economic crises of the late

1980s and early 1990s. The study also examines corporate credit unions and recommends increased

oversight and new rules to prevent these institutions

from investing in risky financial instruments. AB,

10/31/97.

INTERNATIONAL DEVELOPMENTS
 

Japan

On November 17, 1997, Hokkaido Takushoku

Bank Ltd. collapsed. It is Japan's tenth­largest bank

and the first of Japan's ten major commercial banks to

require a bailout. Japan extended emergency central

bank loans and arranged for North Pacific Bank to

take over the failed bank's deposits and outstanding

loans. The New York Times, 11/17/97.

One week later, on November 24, 1997, Japan's

fourth­largest securities company collapsed.

Yamaichi Securities Co. was unable to borrow sufficient operating funds after two U.S. ratings companies rated its credit as "junk." The company also

disclosed that it had nearly $1.6 billion in previously

undisclosed losses that were hidden off its balance

sheet. The Wall Street Journal, 11/24/97.

On January 12, 1998, The Ministry of Finance

reported that Japanese commercial banks' bad loans,

nonperforming loans, and loans with potential risks

totaled 76.7 trillion yen (approximately $590 billion),

which is 14 percent of their total loans of 624.9 trillion yen. Prime Minister Ryutaro Hashimoto

announced that his government was drafting amendments to the Deposit Insurance Law and Financial

System Stabilization legislation in order to help stabilize the Japanese financial system. The amendments would allow the governmental Deposit

Insurance Corporation (DIC) to conduct on­site and

other types of investigations of failed banks and

allow public prosecutors to indict parties who block

the investigations. BBR, 1/19/98, p. 101.

Japan's Ministry of Finance has agreed to allow

banks to have banking subsidiaries without establishing a bank holding company. A ban on holding

companies was lifted last year, which enabled a bank

28
Recent Developments

to establish a bank holding company under which it

can own securities and other financial subsidiaries.

However, not a single bank has expressed intentions

to establish a holding company because of complexity related to the transfer of assets between the holding company and subsidiaries, and other details. The

Ministry thus came up with the amendment in an

apparent move to encourage bank mergers and

improve their efficiency and productivity. BBR, 1/26/98,

p. 153.

On February 16, 1998, the Japanese Diet passed

two bills that will provide 30 trillion yen ($260 billion) in taxpayer money to assist in the disposal of

commercial bank nonperforming loans and to reinforce the protection of depositors. The Law for

Emergency Measures for Financial Function

Stabilization gives the Deposit Insurance

Corporation the authority to issue government bonds

and borrow 10 trillion yen. The government would

use the borrowings to purchase commercial banks'

preferred shares and subordinated debt securities in

the event of bank failures. The other measure

approved by Japanese legislators includes amendments to the Deposit Insurance Law that allow the

Deposit Insurance Corporation to issue seven trillion

yen worth of government bonds to compensate for

commercial bank losses. It also sets up the government­backed Liquidation and Collection Bank as the

recipient bank of bad loans held by healthy banks.

BBR, 2/23/98.

Indonesia

Indonesia plans to merge four big state­owned

banks into one institution in an effort to clean up the

poorly managed and inefficient government financial

institutions. The plan will also allow foreign banks to

buy into any state­owned bank. The Wall Street Journal,

1/2/98.

On January 27, 1998, the Finance Ministry

announced a package of measures that is intended to

restart the flow of money into the economy. The

package included guarantees on bank deposits, an

end to all curbs on the foreign ownership of banks,

and the creation of a special agency that would rehabilitate ailing banks. The New York Times, 1/27/98.

South �orea

In December 1997, the South Korean government

received a $55 billion bailout package from the

International Monetary Fund in exchange for an

agreement to dismantle the country's interlocked

financial and industrial system, known as Korea Inc.

In accordance with the IMF agreement, the government closed ten of the country's 30 merchant banks

in February 1998. A government­backed bridge

bank was created to assume the failed institutions'

assets and liabilities. The Wall Street Journal, 12/4/97, 2/2/98.

United �ingdom

On October 28, 1997, the U.K. Securities and

Investments Board changed its name to the Financial

Services Authority (FSA). The name change is part

of a broad revision of the regulation of U.K. financial

markets aimed at consolidating banking supervision

and investment services regulation into one regulatory body.

One of the first actions taken by the FSA was the

signing of an information­sharing memorandum of

understanding with the Bank of England and two

U.S. regulators, the SEC and the Commodity

Futures Trading Commission. The MOU is expected to enhance the ability of the regulators to obtain

information about the activities of U.S. and U.K.

internationally active firms. It also sets forth procedures for co­operation when addressing potentially

significant market events experienced by U.S. or

U.K. securities or banking firms. BBR, 11/3/97, pp. 696-97.

China

On February 28, 1998, China's top legislative

body, the Standing Committee of the National

People's Congress, gave approval to the Ministry of

Finance to issue $33 billion of domestic bonds to bail

out the country's state bank monopoly. Ninety percent of the country's bank assets are controlled by

four state­owned institutions. Authorities have also

proposed that China introduce a deposit insurance

plan and appoint a federal agency to audit all bank

assets for the first time since 1949. BBR, 3/9/98, p. 410.

Russia

Russia's central bank withdrew 316 banking

licenses in 1997, which is more than 15 percent of the

country's banks. The central bank is continuing to

weed out the country's weakest financial institutions

and will be quicker to withdraw licenses in the

future. Analysts predict the number of banks will

continue to decline sharply this year, as smaller banks

struggle to survive in the low inflation environment

and bigger banks seek to expand by merger or acquisition. Financial Times, 1/7/98. 

29
FDIC Banking Review

102 Nations Sign Financial-Services
 

Pact
 

On December 13, 1997, a deal was reached

between 102 nations, which will open up foreign

markets to banks, insurance companies, and other

financial institutions. The deal, which was coordinated by the World Trade Organization (WTO) and is

the result of seven years of work, is expected to boost

world growth and restore confidence in the Asian

financial markets. The range of services covered

under the agreement is broad and includes: traditional banking services, such as depositing and lending; securities services, including trading in equities

and derivatives; and insurance services, including the

sale of insurance, brokerage, and reinsurance. 

The agreement's main achievement is that it locks

market access offers into a legally binding framework. Any signatory country that does not adhere to

the agreement must answer to the WTO's Dispute

Settlement Body and face the possibility of trade

sanctions. The agreement will be open to participating governments for signature in January 1999 and

will take effect in March 1999. Developing countries

will have phase­in schedules that will allow some

governments to wait until 2020 to completely implement their financial­services offers. BBR, 12/22/97, pp.

922-23.

�uidelines on Internal Bank Controls

On January 19, 1998, the Basle Committee on

Banking Supervision issued a series of guidelines

designed to improve the evaluation of internal bank

controls. The guidelines call on national banking

supervisors to ensure the establishment of improved

management oversight and control structures in

banks under their authority. The guidelines also

require banking supervisors to ensure that banks are

carrying out adequate risk assessments and to

address other issues such as improving internal communication, and monitoring and evaluation of internal control systems in banks. The guidelines reflect

a growing concern about the adequacy of existing

internal controls. BBR, 1/26/98, p. 149.

30