Hirohide Yamaguchi: Challenges for Japanese financial institutions after
the financial crisis
Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at the Retail
Finance Strategy Conference 2009, Tokyo, 25 November 2009.
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Introduction
Thank you for having me at the Retail Finance Strategy Conference 2009. It is my great
honor to have an opportunity to speak in front of you who have been in the front line of
business.
Japanese financial institutions have been significantly affected by the current global financial
crisis. The impact has spread over to the area of retail banking through deteriorating the
business performance of small- and medium-sized firms and sluggish sales of mutual funds.
I will talk today about my views on the challenges for Japanese financial institutions after the
current crisis, and offer my thoughts on approaches to meeting the challenges. I hope my
speech can shed new light on your thinking of retail banking strategies.
I. Looking back at the global financial crisis over the past year
It is more than a year since the failure of Lehman Brothers in the autumn of 2008. Once
turbulent global financial markets have recently regained stability mainly due to ample
liquidity provision by central banks around the world. The global financial system has also
been gradually regaining stability, thanks to, among others, the effects of injections of public
capital into major U.S. and European financial institutions. Meanwhile, the global economy
deteriorated rapidly up to the spring of this year, but has been on a recovery path supported
by policy responses on the fiscal and financial front as well as firms' efforts in production
adjustment.
To start with, the crisis resolution is only halfway through both on the economic and financial
fronts. The balance sheets of financial institutions in the United States and Europe have
been deteriorating, including loan assets, and the completion of their adjustments are likely
to take some more time. I would say that the global financial system as a whole still retains
vulnerability.
Arguably, the essence of the current global financial crisis is the generation and burst of the
credit bubble. While many reasons have been pointed out, I will point out particularly these
three.
First, as accommodative financial environment continued on a global scale up to the middle
of the 2000s and price stability and high economic growth were achieved, many "excesses"
were generated in the risk-taking activity of various economic entities.
On the real economic activity front, for example, against a backdrop of the sustained rise in
housing prices, the household sector in the United States increased borrowing and
significantly increased consumption. On the financial front, new types of transactions such as
securitized products and derivatives prevailed, and leverage increased. Such "excess" in real
economic activity, asset prices and financial markets influenced each other to generate
further "excess." Once the credit bubble burst, the unwinding of the leverage began, and
liquidity in the global financial markets rapidly contracted. On the real economic activity front,
firms were forced to curtail aggressively their production due to the pile up of inventories, and
the global economy contracted significantly.
Second, as what is the other side of same coin of the macro aspects that I have just
mentioned, the micro financial institution behavior also went too far under inadequate risk
management or overconfidence.
Since the turn of the 2000s "the originate-to-distribute model" became common among major
financial institutions in the United States and Europe, and it has been said that, in such a
process, loan screening lacked substance at financial institutions that were the originators of
loans. Financial institutions that were supposed to have transferred credit risk through
distribution were forced to repurchase securitized products after the crisis occurred, and
were reminded of a major misconception about their risk recognition at the time of
distribution. Even as for liquidity risk, in retrospect, it was revealed that financial institutions
significantly underestimated the market liquidity, mainly of securitized products. Such lack of
proper risk management and others led to financial institutions' excessive risk-taking activity.
However, once the unwinding of leverage began in tandem with the outbreak of a financial
crisis, financial institutions in the United States and Europe incurred massive losses, which
made their risk-taking stance rapidly cautious. That was typically shown in the current decline
in lending of financial institutions in the United States and Europe.
Third, it cannot be denied that somewhat slow responses by the policy and supervisory
authorities in the United States and Europe to the generation of the credit bubble preceding
the crisis also eventually amplified the current crisis.
One reason for that was the difficulty the policy authorities and supervisory authorities had
faced in identifying the location and the size of risks, due to the expansion of the so-called
shadow banking by insurance firms, monoline companies, and hedge funds. That was one of
the factors behind the recent review of regulatory and supervisory systems overseas. On the
monetary policy front, it can be pointed out that central banks had not organized their
thoughts with respect to the containment of the credit bubble, including how a central bank
should respond to asset price developments. Namely, while there was a standpoint to argue
that "a central bank should not apply monetary policy to asset price developments but should
carry out aggressive monetary easing after the burst of a bubble," there was another
standpoint to argue that "considering the magnitude of the adverse impact on the economy
following the burst of a bubble, a central bank should conduct monetary policy to avoid the
generation of a bubble." In short, there was no consensus among the central banks around
the world on how to ensure macroprudence. Based on the current financial crisis, central
banks have commonly recognized the importance of analyzing and assessing the financial
system as a whole by eyeing the relationship between the real economy and the financial
system from a viewpoint of macroprudence. And, how to cope with asset prices on the
monetary policy front is expected to be further discussed in the future.
Those are the issues that I particularly deem important concerning the generation and burst
of the current credit bubble.
In the U.S. and European financial markets, there have been lively discussions on the
rebuilding of financial institutions' business model, taking into account the experience of the
current crisis. Many may feel it uneasy to apply directly the discussions overseas on financial
institutions' business to Japanese financial institutions. Such feeling might come from the
significant difference in how the current crisis arose in the United States and Europe, and in
Japan. Namely, for Japanese financial institutions, unlike the U.S. and European financial
institutions, the first-round effects associated with the turmoil in structured product markets
have been relatively marginal while the second-round effects associated with the economic
downturn and the plunge in stock prices have been profound. Now I will talk about the
characteristics of Japanese financial institutions and the challenges for them by also referring
Financial System
to the results of the analyses made in the Bank of Japan's biannual Report.
II. The present state of Japanese financial institution management
Characteristics of Japanese financial institutions' management
Japanese financial institutions and financial institutions in the United States and Europe are
the same in terms of exerting the important financial intermediation function, but quite
different in terms of business model and risk-taking stance.
First, in Japan, deposits are dominant in the financial assets of the household sector, and at
Japanese financial institutions, both the major banks and the regional banks, traditional
commercial banking that focuses on deposit-taking and lending still carries much weight.
As previously mentioned, financial institutions in the United States and Europe have recently
expanded the originate-to-distribute model, and, in terms of profit, have been increasingly
relying on the fee business and the trading business. Japanese financial institutions, mainly
the major banks, have been strengthening investment banking and asset management
businesses. However, deposit preference in the household sector has been deeply rooted,
and the pattern that financial institutions using their deposits as a source of loans and
investments, mainly in government bonds, has not changed much. As a result, while the ratio
of borrowing from financial institutions to firms' aggregate funding except for stocks is about
20 percent in the United States, that ratio reaches 50 percent in Japan. Also from that point,
you can see that the flow of funds through deposits and lending in Japan is still dominant.
Second, in terms of transaction relationship between financial institutions and customers,
while financial institutions are gradually shifting to focus on the profitability of individual
transactions, the stance of building a long-term stable business relationship based on overall
profitability appears to persist.
Such focus on the long-term transaction relationship is by no means unique to Japanese
financial institutions, and is also observed in U.S. regional banks. However, in the United
States, such business relationship with customers seems to have been changing with the
expansion of securitized markets. In addition, in the area of small firm lending, small
business loans that simplify the screening process have increased mainly in major U.S.
banks. That can also be considered as an expansion of lending business that is not based on
the long-term customer relationship.
Also in Japan, the long-term relationship between financial institutions and customers once
called a main-bank system has been gradually waning and transactions that attach
importance to individual profitability have been emphasized. Small business loans were also
once actively used in Japan. Financial institutions have come to provide fine-tuned services
to depositors according to their outstanding amount of deposits and the frequency of the use
of services, and have not necessarily consider their profitability in the context of long-term
transaction relationship. However, such changes in the transaction relationship proceed only
gradually and it appears that the financial institutions' basic stance of pursuing the long-term
stable transaction relationship with customers has not changed substantially. For example,
the practice of cross-shareholdings between financial institutions and large firms still
remains, albeit declining in size. It seems that the regional financial institutions have also
been focusing on the long-term transaction relationship with local firms as in the past.
Third, in terms of risk-taking, Japanese financial institutions generally appear to have been
maintaining a cautious stance.
Behind that was a powerful effect of Japanese financial institutions' experience of incurring
massive losses in the aftermath of the bursting of the bubble in the 1990s. One of the
lessons learned from the bubble and its burst was the size of risk of concentrating credit on
specific industries or firms. While it was difficult for some financial institutions to pursue
active risk-taking until they completed their repayment of public funds, I believe that
Japanese financial institutions as a whole generally appear to have been maintaining a
cautious risk-taking stance based on the experience I have just mentioned.
Effects of the financial crisis and challenges for Japanese financial institutions
As seen above, Japanese financial institutions faced the current global financial crisis without
being able to change substantially the existing management characteristics. As a result, the
first-round effects of the crisis, namely the losses stemming from investments in U.S.
securitized products and originate-to-distribute-type operations in the U.S. and European
financial markets, has remained relatively limited as mentioned before.
The second-round effects brought about by the current financial crisis, namely, the losses
stemming from the economic downturn and the plunge in stock prices have by no means
been limited. Net income of Japanese financial institutions in fiscal 2008 made an about-turn
to mark net losses of about two trillion yen from net profits of about two trillion yen in fiscal
2007, due mainly to the increase in credit costs and losses related to stocks. In that regard,
the aforementioned characteristics of Japanese financial institution management seem to
have rather worked in an adverse way to the deterioration in business performance. In other
words, the current crisis has highlighted the basic challenges inherent in Japanese financial
institution management. Let me elaborate those challenges.
First, low profitability of financial institutions.
While Japanese financial institutions' profits recovered significantly after the middle of the
2000s, it was mainly attributable to the reversals in loan-loss provisions, thanks to the
progress in the disposal of impaired assets and economic recovery. For example, the sum of
net income of Japanese financial institutions for the past 20 years is in the red. While the
sum includes significant losses stemming from the disposal of impaired assets after the burst
of the bubble, the net income of Japanese financial institutions remains quite low even if
those losses are excluded.
The major reason for such low profits is the low interest income. Looking at the interest rate
margins on loans (i.e., the interest rate on lending minus the interest rate on deposits), which
is one component of interest income, for the past 20 years, the margin has been five to six
percent on average for U.S. banks, while it has remained at slightly below two percent for
Japanese financial institutions. The main reason behind such low interest rate margins of
Japanese financial institutions is attributable to the fact that many financial institutions have
basically been consistently in the interest rate competition as they compete with each other
in the relatively homogenous commercial banking business with an aim to obtain a long-term
stable transaction relationship. In short, the difference in business model by financial
institutions is hardly observed. According to the analysis of the lending market in Japan,
many financial institutions tend to enter the regions that have a large lending market, thereby
intensifying competition. By contrast, in the U.S. market, there is no significant correlation
between market size and market concentration, which suggests that certain segregation
among financial institutions might be in place. While it is not clear why such a segregation
was possible, it is clear that the segregation enabled financial institutions to avoid the
needless interest rate competition.
Of course it is not the case that Japanese financial institutions themselves have not been
doing anything to cope with such low profitability. Signs of expansion in the investment
banking business, including M&A business, have also been continuing in Japan. Small
business loans were once actively promoted. However, since credit costs increased
significantly, many banks have recently been forced to downsize or withdraw from the small
business loan operations. As for household asset management, the expansion of
over-thecounter sales of mutual funds and insurance has been pursued. Moreover, at the major
banks, the efforts to bring consumer credit companies, credit card companies, and consumer
finance companies under the banks' umbrella were temporarily intensified. However, the
profits from those affiliated companies have been sluggish, partly due to the changes in the
environment they are in. After all, the fruits of pursuing new businesses have not been
sufficient so far, and, at present, the new businesses have not contributed in a significant
way to improving the profitability of financial institutions.
Second, Japanese financial institutions' profits are subject to the fluctuations in credit costs
and stock prices.
In particular, as operating profits from the core business have been remaining low, a
significant increase in credit costs and losses on stocks might immediately bring periodical
income into the red. In fact, eight times in the past 20 years, the sum of credit costs and
losses related to stocks reached a level more than that of operating profits from the core
business.
While the level of credit costs fairly declined, reflecting the completion of the disposal of
impaired assets, it started to rise again in fiscal 2008 due to the economic downturn. In
addition, the outstanding balance of financial institutions' strategic cross-shareholding was
reduced almost by half during the disposal process of impaired assets in the early 2000s for
the major banks, and remains almost unchanged since then. That suggests that the practice
of cross-shareholding between financial institutions and firms remains, and, at the same
time, the current outstanding amount of shareholding is still a factor in inducing large swings
in financial institution profits.
While the challenges cannot be met easily, I expect financial institutions to consider them
now as a golden opportunity and step up their efforts in order also to maintain and further
arouse the vitality of Japan's economy.
III. Approaches to meet the challenges
Strengthening capital base consistent with risks
Next, I will offer my views on what kind of approaches might be necessary for meeting the
challenges.
First, strengthening capital bases that are consistent with the risks held by financial
institutions.
The review of the regulatory framework including the capital adequacy ratio for financial
institutions has been discussed globally. It is expected that an initial draft of a new regulatory
system will be presented between the end of this year to the beginning of next year, and after
conducting quantitative research on the influence of a new system, a final draft will be
completed by the end of 2010.
It is necessary to carefully examine how a new regulatory system would affect the financial
system and real economic activity. However, it is critical for individual financial institutions
themselves, independent of the discussions on such a regulatory framework, to strive to
strengthen their capital bases that are consistent with the risks they hold.
After all, capital is the last resort as a buffer to absorb losses. What became a catalyst for the
global financial system to gradually regain stability after the current crisis were the efforts by
U.S and European major financial institutions to restore their capital through receiving public
capital or raising private funds in the markets. Concerning Japan's financial system as a
whole, macro-stress tests conducted in the Bank's Financial System Report showed that
Japanese financial institutions' capital bases are not likely to decline substantially even in the
situation where severe future macroeconomic conditions are assumed. However, as
mentioned earlier, in the case of Japan, there is the problem that banks' profits tend to
fluctuate according to economic developments, which lead to changes in capital. In addition,
if financial institutions pursue a new business strategy to meet a variety of needs from firms
and households, capital bases that can tolerate risks of a certain degree need to be
enhanced. Both the major banks and the regional banks have recently been reinforcing their
capital bases, which the Bank regards could lead to ensure soundness of individual financial
institutions as well as the stability of the financial system as a whole.
Appropriate risk management
Second, the importance of appropriate risk management.
For a financial institution, risk management is essential in ensuring management soundness
and maintaining the smooth financial intermediation function as well as a key to ensuring
profits. In terms of credit risk management, Japanese financial institutions have been
improving their screening skills, based on the experience of the bubble period during the
1980s, and have made fair accomplishments. However, the deterioration in firms' business
performance triggered by the current financial crisis has progressed at an unprecedented
pace. Taking that into account, it becomes important for financial institutions, in addition to
improving their screening skills, to strengthen follow-up management, and further strive for
supporting corporate rehabilitation. Moreover, the finely-tuned setting of lending interest rates
according to credit risks continues to be an important challenge.
In terms of market risk management associated with stockholdings, the size of strategic
cross-shareholding will be basically left to firms' and banks' business strategies. However,
the current market risk associated with stockholdings of Japanese financial institutions as a
whole remains to be high relative to capital bases, and a steady reduction in the amount of
that risk is no doubt a critical challenge for financial institution management as well as for the
stability of Japan's financial system.
Building a business model to strengthen profit base - focusing on retail banking
Third, building a business model to strengthen the profit base. While I will focus on the topic
of today's speech, retail banking, reinforcement in the area of wholesale banking is also
essential for strengthening the profit base. Retail banking could provide higher value-added
services by managing it in an integrated way with wholesale banking. For the major banks,
how to formulate coordination between wholesale and retail banking would be one of the
keys to rebuilding their business model after all.
(1) Operations related to deposits, payment and settlement, and asset management
To that end, first I will take up the role of operations related to deposits, payment and
settlement, and asset management.
After the current financial crisis, a phenomenon to be seen as "back to basics" of financial
operations has been occurring in the United States and Europe. Proprietary trading of
complex products, such as securitized products and derivatives, has complicated the risk
profiles of financial institutions and made risks difficult to manage. Based on such
recognition, a move to return to the traditional business based on customer transactions has
been emerging. The move includes a re-evaluation of traditional businesses related to
deposits and payment and settlement while taking into account a viewpoint of improving the
management of liquidity risk. Those businesses are, so to speak, the areas Japanese
financial institutions have been good at.
One question for financial institution management in Japan is whether the costs associated
with maintaining deposit bases are commensurate with the profits. Retail banking is
associated with a variety of unique factors that lead to an increase in costs, including ATM
that operates 24 hours. Meanwhile, to charge fees for the current deposits whose balance
dropped below the required minimum balance is not gaining customers' understanding.
While how to balance the costs and profits is an important management judgment, it would
be absolutely necessary for financial institutions to avoid the possibility of running below
break-even. As financial institutions are expected to provide fine-tuned services to
households reflecting their outstanding balance of deposits and the degree of use of
services, it would be necessary to check the balance between the quality of services and the
cost sharing.
In addition, if one assumes a situation in which households' asset accumulation further
progresses and their asset management diversifies, it would be essential to enhance the
services to support households' asset management. Such services are currently provided in
the form of over-the-counter sales of mutual funds and insurance, and asset management
services. By properly gauging the needs of customers and enhancing the provision of
services, I believe it important that the fee business steadily takes root.
(2) Personal loans
Second, the role of personal loans. In Japan, housing loans have overwhelming weight and
accounts for about 20 percent of the financial institutions' total lending.
Housing loans in Japan have been increasing steadily even under the current financial crisis.
The problem is its profitability. According to the Bank's analysis, the profitability of Japanese
financial institutions' housing loans has been consistently declining recently. For example, if
the profitability of housing loans during the life of a loan that was lent in fiscal 2003 and fiscal
2007 is compared on a present value basis, it will decline by about six percentage points. If
the default rates rise significantly in the future, it cannot be denied that banks' profits will
plunge. The profitability of housing loans also warrants careful monitoring.
In addition, consumer loans such as card loans and car loans are an area where potential
needs exist over time. With a view to its potential, the major banks have been increasing
their capital subscription to consumer credit, credit card, and consumer finance companies.
As explained earlier, those affiliated companies have not contributed to increasing the profits
of financial institutions, while the future developments in the area of consumer loans warrant
attention.
(3) Lending to small- and medium-sized firms, and provision of risk money
Third, fund provision to small- and medium-sized firms.
Firms' funding conditions rapidly deteriorated from the autumn of 2008 to the beginning of
2009, and have been recently improving, partly due to the recovery of CP and corporate
bond markets. Many small and medium-sized firms still view their funding conditions as tight,
and the Bank considers that the smooth fund provision to small and medium-sized firms
continues to be an important challenge for corporate finance in Japan.
Looking at the future of Japan's economy, how to provide risk money to small- and
mediumsized firms with high technology would be a challenge for the financial system. In that case, it
becomes important to apply part of households' ample financial assets to risk money.
In Japan, while the importance of venture capital has repeatedly been argued, it has not
grown in a significant manner so far. Providing risk money smoothly to firms that have a
possibility of leading Japan's future economic growth is one important challenge in the area
of retail banking. The Bank will keep monitoring with strong interest what type of financial
institution will play a role of intermediation through what type of channel.
Concluding remarks
The current financial crisis has posed various challenges to the Bank of Japan.
One of them is, from a macroprudential perspective and taking into account the
interconnectedness between the real economy and the financial system, to analyze and
assess the risk of the financial system as a whole. The Bank of Japan has been tackling
Financial System Report
such challenge through and others, and intends to further enhance
its efforts as well as to continue to strive to properly gauge and assess the risk inherent in the
financial system.
On that basis, the Bank considers that how to utilize such assessment in monetary policy or
to utilize in further strengthening of financial institutions' risk management through on-site
examination, off-site monitoring, and the activities of the Center for Advanced Financial
Technology, would be our next challenge.
Amid changing global economic and financial conditions after the financial crisis, Japan's
economy is also faced with a difficult situation from a longer perspective. For Japan's
economy's long-term growth, it is essential to raise the productivity of the economy as a
whole. To contemplate what kind of reform in the industrial structure is required and how that
can be supported on the financial system front, would also be a challenge for the Bank of
Japan. By sharing wisdom with you, the Bank will make the utmost contribution as a central
bank.
Thank you.