Japan’s highly segmented banking industry is made up of separate groups of institutions engaged in short-term or long-term finance; trust activities; foreign exchange, and trade financing; small business finance; and regional and agricultural finance. The segmentation of the banking industry reflects the extensive restructuring the Japanese economy underwent in the aftermath of World War II. At that time, as a key part of Japan’s efforts to promote rapid industrial recovery, the government instituted legal reforms that created pronounced specialization in banking that persists to some degree to the present day. Although the Japanese banking industry remains segmented and specialized, deregulation and liberalization since the 1970s have eliminated many functional distinctions among the different types of banks and the separate, specialized markets they formerly served. Bank regulation and supervision are the responsibility of the central government, although some financial institutions are under the jurisdiction of local governments. The current Japanese banking system had its inception during the late 19th century with the emergence of a commercial banking system that was dominated by a small number of banks associated with major industrial conglomerates. After World War II, the Japanese government’s efforts to rebuild the economy led to the dismantling of these prewar conglomerates and to restrictions on universal banking powers that were formerly allowed to banks. As part of the nation’s postwar economic and industrial recovery reforms, the Japanese government restricted banks from engaging in activities outside of banking, such as securities activities, and it limited their ownership of shares in other Japanese companies, particularly industrial companies. The result was a segmented banking structure, which even today retains some of its highly specialized character. Japanese banks currently may accept deposits or installment savings, lend money, conduct exchange transactions, and certain ancillary activities. Allowable ancillary activities include purchasing, lending, and selling securities; underwriting government bonds; and the safekeeping of securities and precious metals. In addition, through associated companies, banks can provide venture capital, consulting services, leasing, housing finance, and loans. Industry deregulation initiated in the early 1980s that culminated with the 1992 Financial System Reform Law also now allows banks to compete in securities underwriting activities through subsidiaries, albeit with certain restrictions on those activities. In addition, there is to be a clear separation of banking and securities activities. Banks, however, are currently prohibited from participating in insurance activities and from setting up holding companies. The structure of the Japanese banking system is made up of five types of specialized financial institutions: commercial banks, which are referred to as ordinary banks; long-term financial institutions; financial institutions for small business; financial institutions for agriculture, forestry, and fisheries; and public financial institutions, which include a postal savings system that is a major source of funds for the Japanese government. (See app. I.) Ordinary banks in Japan include city banks, regional banks, and branches of foreign-owned banks. They offer a variety of products and services including deposit-taking, fund transfers, and short- to long-term loans, both domestically and abroad. Ordinary banks may also engage in certain government securities activities, including some securities underwriting, and the sale of corporate commercial paper (short-term unsecured funds) to institutional investors and financial institutions. Collectively, city banks are the largest private banks in Japan, whether measured by industry assets, loans, or deposits. They are also among the largest banks in the world. In December 1995, the six largest banks in the world, ranked by assets, were Japanese city banks. Long-term financial institutions in Japan include long-term credit banksand trust banks. Historically, the Japanese government has established long-term financial institutions to provide long-term funds for agriculture and other industries. Until recently, they have been the only institutions permitted to raise long-term funds. Long-term credit banks may issue bank debentures with up to 5-year maturities, and trust banks may handle 5-year trust accounts. Since deregulation of the banking industry, however, ordinary banks are also making longer-term loans, and the historic differences between ordinary and long-term financial institutions have become less pronounced. The group of cooperative-based institutions known as financial institutions for small businesses serves the financial needs of their members, which include small- and medium-sized businesses and labor unions. Also included in this group are three central bodies serving the financial needs of their member cooperatives through such services as deposits and member loans, and a special corporation providing financial assistance for cooperative institutions. Institutions known as financial institutions for agriculture, forestry, and fisheries are made up of entities operating at three levels that serve local cooperatives. On the first level are cooperatives operating at the individual village, town, and city levels of government. These cooperatives in turn are members of a second level of prefectural-level credit federations serving clients within their prefectures. At the third level is the Norinchukin Bank, which in several respects works as the central bank for agriculture, forestry, and fisheries. Japan has 11 wholly owned government financial institutions, of which 2 are banks and 9 are public corporations. These lending institutions, which are designed to supplement private-sector financing, are prohibited from competing with private banks. The institutions’ funds come from loans from the government’s Trust Fund Bureau, which in turn is largely financed by the government’s Postal Savings System. Although the Postal Savings System is not categorized as a bank, the magnitude of its financial resources gives it important financial significance in Japan. As of June 1995, the system held in excess of 200 trillion yen ($1.88 trillion) in deposits, making it the largest financial institution in the world. The extensive system operates out of 24,000 Japanese post offices throughout the country. As of early 1995, the 1,130 financial institutions conducting banking operations in Japan had approximately 1,148 trillion yen ($10.8 trillion) in industry assets, as shown in table 1.1. Ordinary banks alone accounted for over half, or 53 percent, of this total. Ten long-term financial institutions held the next largest share of banking assets, or 28 percent of the total. The most sizable share of banking assets controlled by cooperative-based institutions was held by financial institutions servicing primarily local communities, which had about 12 percent of total industry assets. As of February 1996, there were 90 foreign-owned bank branches in Japan, of which 16 were owned by U.S. firms, according to Japanese government officials. Appendix I provides greater detail on financial institutions in Japan. Historically, Japanese laws for bank regulation and supervision have been simple and limited in scope. The current Japanese bank regulatory and supervisory structure is based on the 1981 Banking Law, which revised earlier banking laws. The 1981 Banking Law designated the Ministry of Finance (MOF) as solely responsible for authorizing and regulating the banking industry in Japan, and it maintained MOF’s legal supervisory authority over banks. While the Bank of Japan (BOJ) lacks the regulatory authority of MOF, it carries out its safety and soundness responsibilities based on the authority granted by the 1942 Bank of Japan Law that BOJ maintain a safe and sound financial system. Changes in the bank regulatory structure have resulted from essentially two stages of evolution in the Japanese banking industry, according to historical literature. The first stage spans the 1860s up to the early 1970s and includes the origin of the banking system as well as regulatory changes following World War II. The second stage, which dates from the mid-1970s to the present, was triggered by the first oil crisis in 1973. The origins of the Japanese banking system can be traced to the Meiji restoration period in 1869, when money-transfer companies with many of the functions of modern banks were established in major cities. Soon after, Japan’s first bank legislation (the National Bank Act) was enacted in 1872. This act created national banks, which were private banks issuing bank notes. The central bank of Japan, BOJ, was founded in 1882, although it was later reorganized under the Bank of Japan Law of 1942. The original 1882 law gave BOJ the sole right to issue bank notes, taking away this responsibility from national banks, most of which disappeared soon after. The Banking Act of 1890 converted the remaining national banks and other private banks into ordinary banks. In the same year, the Savings Bank Act of 1890 established savings banks, whose number then climbed steeply over the next decade to a peak of about 720 banks at the turn of the century. The 1915 amendment to the Savings Bank Act prohibited ordinary banks from engaging in similar savings activities until World War II, when the expansion of savings became a national policy goal. At that point, ordinary banks were allowed to conduct the same business activities as savings banks and, as a result, savings banks began to disappear. In response to a nationwide financial panic in 1927, which heightened concerns about the stability of the Japanese banking industry, the government enacted the Banking Law of 1927. This law, which defined the structure and organization of Japan’s banking system for the following 54 years, established a banking system focused on short-term lending. Fundamental changes to BOJ’s governance structure enacted in the 1942 Bank of Japan Law also made BOJ a means for conducting monetary policy. Prior to 1942, BOJ was a stock corporation that was directly accountable to its stockholders. However in light of wartime conditions, the 1942 law gave the government influence over the bank’s operations. The government became the majority stockholder of the bank, while voting rights were denied to all stockholders. The 1942 law, according to BOJ officials, provided BOJ a legal basis to foster and maintain a sound financial system. In particular, BOJ believes that the law provided a stronger statutory basis for conducting its safety and soundness examinations of client banks, which began in 1928. In addition to on-site examinations, BOJ relies on frequent contacts to ensure that financial institutions follow sound practices.