The origin of Japan’s financial crisis is a thriller, or perhaps a horror story, as penned by Gillian Tett in her book “Saving the Sun”.
A social anthropologist rather than an economist, Tett tells the story of Long Term Credit Bank, LTCB (later renamed Shinsei), which epitomized Japan’s banking problems. It is a story of greed, hubris, corruption and at time madness. Above all, it is a story of a government-led system which lost touch with reality.
Understanding Japan’s financial crisis is critically important to us all as the world is currently mired in the global financial crisis. Somehow we need to bring to an end these never-ending financial crises which are simply tearing our world apart. But the Japanese themselves need to understand better their own crisis – from which, some 20 years later, they still have not fully recovered.
LTCB was once the world’s 9th biggest bank, with origins dating back to the Meiji era. It collapsed in 1998 with $50 billion of bad loans, much of which had not been visible before. It was then nationalized and sold in 2000 to a group of American-led international private equity investors.
The starting point in understanding Japan’s banking crisis is the country’s post-war banking culture. The government was fully motivated to push rapid economic reconstruction and development. It believed that banks should be key to financing that development. It thought that relying on stock and equity markets could be risky, as the government might have different priorities from individual investors.
Several types of banks were created, including long term credit banks which channeled long term investment loans to special priority sectors identified by the government – initially shipbuilding, power companies, steel and coal mining, and then later car manufacturers. By 1963, LTCB alone had poured several hundred billion yen in companies like Toyota, Toray, Kawasaki Steel, Tokyo Electric Power, Bridgestone and Toshiba.
(In this system stock markets were not for speculation or investment purposes, but a means for companies to solidify ties to each other through cross shareholding. These ties linked groups of companies into specific corporate families known as “keiretsu”.)
Assessment of possible loans took into account whether the loan would be for a priority sector, and whether it was to a company that was judged viable. No assessment was made of the project for which the loan was sought. What was critical was developing, maintaining and supporting the relationship between the bank and the borrowing company, whether a loan was sensible looking at the entire company and its keiretsu relationships. This is not very dissimilar in spirit to Japan’s main bank whereby, for example, Mitsubishi companies would always borrow money from Mitsubishi Bank.
The government set low interest rates, which limited investment returns for citizens. But also it provided low interest loans for Japanese companies. Interest rates on loans were not based on risk, or with a view to making profits. In fact, high risk companies paid the same as low risk companies.
So, the first key element in the story is that long term credit banking was based more on relationships than lending money to the most profitable activities.
As Japan developed rapidly, so did lending activities by LTCB and the other long term credit banks. But as “developmental institutions”, their role became less necessary by the 1970s. Successful industrial companies were building up cash reserves, and had less need for external finance. With financial market liberalization in the 1970s, corporate bond markets developed. And some companies were also becoming strong enough to raise money on international markets.
At this time, the long term credit banks could have been abolished, having successfully fulfilled their role of supporting Japan’s post-war economic recovery. But in the Japanese bureaucratic system (and most bureaucratic systems), nothing is ever abolished once it is created.
Into the 1980s, LTCB was looking for new areas of activities. It wanted to move into investment banking – corporate finance, project finance, derivatives and securities operations. But the Ministry of Finance which maintained a stranglehold on the financial system would not let it do so in Japan, although it could do so overseas.
Around this time, the price of real estate and stock market shares were increasing rapidly. Japan was prosperous, and its citizens had plenty of savings. But they could not invest overseas because of exchange controls, nor could they earn much in interest from banks. So they started investing in real estate and the stock market, as did investor groups.
Adding fuel to the fire was a strengthening of the yen exchange rate. In 1985, Japan was, like China today, the international bad boy with a big current account surplus, and undervalued exchange rate. So the Americans and the G7 pushed Japan to let the yen strengthen, and it surged from Y240 to the dollar to Y150. To boost demand, the Bank of Japan cut interest rates and ran an easy monetary policy. Suddenly real estate and share prices were spiraling higher and higher.
With this LTCB made more and more real estate loans. No-one believed that real estate prices (or stock Prices) would ever drop. No Japanese financial institution had failed. Everything seemed rosy.
This was the time of the “Japan is Number One” fever. LTCB bankers started to ooze with self-confidence. By the late 1980s, lTCB felt so self confident that the decided to erect a lavish new 20-story tower over the Imperial Palace. They were fired up with the belief that they were now carrying the message of Japan’s might out into the wider world. Japanese investor bought all sorts of things like the Rockefeller Centre and the Exxon Building in New York, and Columbia Pictures.
Tett recounts the LTCB financed investment by Electronics and Industrial Enterprises (EIE) for a New York hotel. LTCB analysts valued the transaction at $150 million, but EIE wanted and was given $350 million in financing. Without any financial analysis, LTCB’s Tokyo headquarters instructed the New York -- “Give Takahashi (EIE’s CEO) as much money as he wants”. They said that it is ridiculous to worry about cash flows or rates of return -- that is the type of thing that Americans did!.
Takahashi also invested in other hotel projects like the Saipan hotel and Regent hotel in Sydney – “I want that hotel”. And in late 1989, EIE moved out of its scruffy, fourth floor office in Ginza into new headquarters in Akasaka. They bought pieces of art by Chagall and Picasso.
The Japanese economy was clearly experiencing a real estate and stock market bubble. By December 1989, the Nikkei 225 had reached 39,000, four times its level in 1980.
In late 1989, the Bank of Japan decided that it was time to cool the bubble. It sharply increased interest rates on Christmas Day 1989, hoping that it would slow the rise in real estate and stock prices. The Nikkei tumbled and the real estate market started to slip.
The Japanese banking system was based on mutual support between companies and banks, and also constant growth. And as real estate prices starting falling, the system fell apart with loans to real estate investors quickly becoming non-performing loans (NPLs). As interest rates rose, EIE needed to borrow morning just to pay debt servicing. Some 80% of bank lending was directly or indirectly linked to real estate.
Rather than recognizing and writing off these NPLs, the initial reaction of bankers and bureaucrats was to sit tight. They believed that growth would return and that no radical action was necessary. This meant of course as real estate prices kept falling, more and more loans became NPLs. And even more NPLs were created as finance continued to be given to these zombie companies. With the cognizance of the Finance Ministry, banks were illegally cooking the books in several ways – shifting NPLs to subsidiaries, and refusing to recognize or even hiding NPLs. As the 1990s wore on, lTCB’s exposure to risky companies was actually increasing.
In a Western country, investigative journalists might get wind of this, and start reporting. But mainstream media in Japan was traditionally part of the system. The NGO sector was also repressed.
But moving into the 1990s, things started to change. Egged on by opposition party politicians, corruption scandals were exposed. Takahashi had provided lavish entertainment to bureaucrats, politicians and bankers – golf tournaments, holidays, wild evenings at no-pan shabu shabu restaurants.
Japan’s old way of doing business led to a proliferation on non-performing loans as banks like LTCB failed to get tough with deadbeat borrowers. LTCB was nationalized in 1998 with $50 billion, and sold in 2000 to a US-led private equity consortium.
As soon as the new consortium took over, they discovered many hidden non-performing loans, and much resistance to new ways of doing business. And more than that, there was utter shock in the staff canteen when the new American management team came down to have lunch with their new colleagues. At LTCB a rigid hierarchy governed the lunchtime universe, like everything else – and everyone was supposed to keep to their allotted place.
There was great public outcry when they refused debt forgiveness to Sogo. They had great difficulty in getting the government to honor an agreement for hand-back of bad loans.
However, within four years, they had disposed of bad loans of 3 trillion yen, and the bank was profitable again. It was then sold back to the market.
Tett’s story highlights how paralyzing can be Japan’s traditions of consensus thinking, harmony, hierarchy, insularity and resistance to change. She concludes that “A profound rift still exists between Japan and the rest of the world … the Japanese press, government, and people have all but turned against the idea of American-style capitalism. Indeed, instead of reforming Japan, the banking crisis may have convinced ordinary Japanese, more than ever, that they must go it alone”.
A key aspect of capitalism is what Schumpeter called creative destruction – getting rid of the old and creating the new. By keeping zombie companies and by extension zombie banks afloat, Japan simply deprived itself of new economic creativity.
We should never forget what in concrete terms are the differences between capitalist banking systems and Japan’s old relationship based banking system. Banks are just intermediaries between savers and investors. In Japan’s old system, banks paid poor savers like you and me a pittance in interest for their savings, and then lent the money to companies based on more on their relationship than whether it was a wise investment. All too often, these loans were badly invested. Capitalist banking systems seek to provide savers with a competitive rate of return, and place investments in high rate of return projects.
One of the most damaging quotes in the book comes from a UBS banker who said “I think that there is a huge capacity for self-delusion among the Japanese … This is dangerous because they cannot rationalize things. There is just this huge self-deception about reality”.
Saving the Sun: Shinsei and the Battle for Japan’s Future by Gillian Tett
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