Solutions to Japan's Banking Problems: What Might Work and What Definitely Will Fail

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Abstract
We study the longstanding banking problems in Japan. By examining both the past policies in Japan that have failed, and the successful policies in other high income OECD countries that have overcome banking crises, we develop a roadmap for resolving the problems. We distill the problems into four basic troubles. The first is that most of the banks are severely under-capitalized when their condition is properly evaluated. The second is that the banks are not currently allocating credit efficiently, and instead are directing many loans to borrowers that will not be able to repay them. The third is that the banking sector is too large (in terms of assets) to make adequate returns. The final problem is that the banks' lack of profitability is partly related to their inability to offer the high margin products that are commonplace amongst their foreign competitors. We then explore the implications of these observations for the long-run condition of the industry. In particular, a natural way to define the end of the problems is when the banking sector has shrunk to a level where it can profitably operate and the banks are once again adequately capitalized and no-longer ever-greening loans to deadbeat borrowers. Recognizing this constellation of conditions as the eventual equilibrium for the industry is helpful because it identifies the set of problems that a successful policy must confront. Our description of the equilibrium also helps to show why past policies have failed to end the problems. The evidence from other countries, however, shows that the problems are not insurmountable. We describe how the successful policies used elsewhere could be applied in Japan. We outline alternative transition strategies that could take us from the current conditions to the equilibrium. Finally, we illustrate the alternatives by analyzing the Resona Bank rescue and the Mitsubishi Tokyo Financial Group and UFJ merger.

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