Financial Issues Toward the Structural Reform of Japan's Economy

Yoshifumi NISHIKAWA (President & Chief Executive Officer, Sumitomo Mitsui Banking Corporation)

The social and economic systems created since the end of the war are showing signs of fatigue, and reforming economic structures is becoming imperative. The same can be said of the banking industry. Japanese banks should not just stop at accelerating the final resolution of bad loan problems, but also should boldly take on the challenge of revolutionizing traditional banking business models.

Final resolution of bad loan problems

Establishment of efficient financial markets grounded on a sound financial system is essential for the creation of a dynamic economy and society suitable for the new century.

The bad loan problem is the utmost concern of Japanese banks, and banks have been aggressively taking steps for its final resolution. From fiscal 1992 to the first half of fiscal 2000, banks disposed of 68 trillion yen in bad loans. Of this amount approximately 80%, or 54 trillion yen, was removed from bank balance sheets through direct write-offs and other methods. Nevertheless, the amount of outstanding bad loans has not decreased rapidly, persisting at about 30 trillion yen for the past two to three years. This is due to the addition of new bad loans, as it is increasingly clear that deflation is taking hold (economic stagnation becoming long term, persistent fall in land prices, etc.).

Some say that the delay in removing bad loans from financial institutions' balance sheets is acting as a drag on the economy and having a direct, negative impact on economic recovery. I strongly feel that the drift of the argument is misguiding, based mainly on the following two factors.

First is the soundness of the banks. Thanks to measures such as infusion of public funds in March 1999, major Japanese banks' capital ratios are in the latter half of the 11% level-a satisfactorily high level-at the end of September 2000. This high level is being achieved despite appropriate loan-loss reserves allocated based on self-assessment of assets conducted every six months according to the Financial Inspection Manual. Third-party evaluation of the process by auditors and financial authorities as well as internal audits also is carried out. Thus, the banks have been maintaining their high capital ratios after disposal of bad loans. Therefore, arguing that there are problems with the health of banks by focusing only on the high level of bad loans is too simplistic.

Second is the banks' function as intermediary for distribution of capital to companies. A credit crunch did indeed develop from 1997 to 1998, but at present the leading banks have high capital ratios and bad loans are not interfering with lending. Rather, given the real economic situation, companies have little appetite for new capital, and coupled with intensifying competition due to weakening of the money supply-demand balance, interest spread on loans is tending to shrink slightly.

It cannot be denied that the high level of bad loans on the books, coupled with the stock market downtrend, is conducive for concerns about Japan's financial system. Given these circumstances, the outstanding bad loan amount and the ratio to the total loan must be reduced quickly. For now we must cut the bad loan ratio sharply from the current approximately 6% level to the 2% level, the level of US banks. However, there are various problems to overcome in further disposal of bad loans. For example, although a systematic framework for legal resolution of debtor firms has been established, Japanese tend to regard a company under rehabilitation as being bankrupt and therefore its enterprise value drops sharply. Moreover, given Japan's unique main bank relationship, adjustment of burden between creditors in private resolution is difficult. Regarding loan sales, as there currently are few suppliers of risk money, buyers of bad loans are limited. Amid these circumstances, banks must use various methods to accelerate disposal of bad loans while expanding debt collection.

Financial reconstruction and industrial reconstruction are like wheels of a car, and are inseparably related. To achieve industrial reconstruction, companies must resolve three excesses of debt, capacity, and workforce, and companies that cannot do so must be pressed to get out of the market. The resolution of the three excesses will be achieved mainly through individual efforts of each company based on drastic restructuring programs. From the banks' point of view, not all of such borrowers' excess debts belong to the bad loan category. Regardless of whether the loans are bad or not, the banks must strongly press the borrowers to cut such excesses through self-help efforts and support such efforts. This will be achieved at huge cost for the borrowers, but there will be cases of pain for the banks also. Nevertheless, the simultaneous reconstruction of the financial and industrial sectors, which will lead to revitalization of the economy, can be achieved only by overcoming such pain.

The situation of US banks is often used to contrast with our current situation. In the first half of the 1990s, US banks sharply reduced their bad loans. The background to this, however, was the robust economy. Consequently, an economic recovery is necessary for achieving double reconstruction.

New banking models

For the creation of a stable financial system and efficient financial markets, banks must establish sound management foundations while responding to various environmental changes such as maturing of the economy, globalization, and the IT revolution. At the same time, they must become competitive on a global scale, and provide products and services that match the diversifying and individualizing needs of customers.

Against this background the Japanese financial industry has been undergoing a large-scale consolidation. There were nineteen major banks in March 1997, but they have now reorganized into eight groups. Through such management integration, each group is assiduously moving to take advantage of economies of scale and economies of scope-the former to (a) improve cost competitiveness, (b) become a price leader, and (c) strengthen capital to withstand diverse risks; and the latter to (a) expand revenue opportunities by cross-selling, and (b) achieve stable management through business diversification.

The banks can gain customers' trust by offering products and services specific to their needs, enhancing their return on assets and providing new value. This in turn will lead to revitalization of the economy.

To realize this, the banks must undergo a paradigm shift from the conventional banking business of taking deposits and making loans to becoming a financial service industry. Large-scale management integration is not the goal in itself, but a starting point. Each bank must apply itself to further innovations and shift to bold, unique business models based on customers' points of view.