Japan’s Woes: Is Bigger Better?

I’ve just returned from another trip to Japan, and I can report, without fear of contradiction, that despite my many visits and copious advice, the country’s economy is still in serious trouble.

Japan’s national debt is 140% of its GDP. (Ours is near 40%+ and Italy’s, the highest of the developed countries, is more than 95%). It has suffered from deflation, 1% to 2% a year for the last few years, and real estate prices are 10% to 20% of their zenith more than 10 years ago. Its productivity growth, the highest in the world a decade ago, is now near zero, and has been for most of the last five years.

Then there are Japan’s banks, which continue to hold huge amounts of nonperforming loans (NPLs) despite the government spending years and more than $100 billion trying to stabilize them with government injections of capital. NPLs are somewhere between 7% to 8% of loans (official number) and 20% of loans (estimates by private sector observers). Because of the weak undercapitalized structure of corporate Japan, along with 10 years of recession and depression, the banks haven’t been able to do much to reduce the percentages of NPLs.

Further, unlike our Resolution Trust Corp., Japan has taken the view that it does not want to make sales of NPLs at distressed prices. I keep telling Japan’s banks they have to “chum the waters,” but that doesn’t seem to translate well.

What Japan has done, with a view toward strengthening its banking system, is help its biggest banks to merge into four giant banks. Mizuho (translated as “sweet spring rice”), the largest of the new banks, is about 30% bigger than Citibank, making it the world’s biggest bank. Japan’s second-largest, Mitsubishi-Tokyo, is about 25% larger than Bank of America, and is now the world’s third-largest banking institution. (The relative size, of course, depends on the dollar/yen exchange rate–the higher the yen, [or when the dollar falls] the bigger the Japanese banks become.)

It is too early to determine whether this group of bank mergers will result in a more efficient competitive banking system, but the evidence so far is not encouraging. The giants have had some real technology problems. Also, the largest banks have been the most resistant to sell off their loans to the Japanese equivalent of the RTC–the RCC–because they cannot agree on a fair price. Furthermore, putting three weak banks together does not increase their capital and, so far, has not improved their productivity. Only two of the big banks are making money this year: the former Long-Term Capital Bank and the former Nippon Credit Bank. Both went through what we would call a “bridge bank” resolution and their NPLs were forced into the RCC as part of the transaction.

Even with the quasi success of these two institutions, Japanese authorities will not permit any more bridge banks or short-term nationalizations to occur, because by creating these behemoths, they have created institutions that are not only “too big to fail” but “too big to sell.” No financial institution could buy a bank the size of Mizuho because the risk and cost would simply be too high. If the Japanese government has to take any of these banks over, it would have to hold them and manage them until it could sell them back to the private sector through an IPO. So far, I don’t see much evidence that bigger is better in Japan, or in the U.S. for that matter.

Japan also has hundreds of small banks and credit unions, most of which are similarly loaded with NPLs. The government is evidently thinking of a new policy to merge these weak banks into larger banks. It also may combine a substantial number of these institutions into one larger bank.

When Japanese officials asked me about this proposed policy, I launched into my standard speech: Overall small banks are good for the system–they provide decentralized lending, they know their home markets, and they offer support to their communities and encourage new enterprises out in the countryside, etc.? Further, we have yet to see a strong bank emerge from combining a group of weak banks.

While it is too soon to see the effects of these proposals, our experience doesn’t support the idea. Bigger doesn’t necessarily mean better, and in Japan, it may even mean “worse.” In any case, it seems clear to everyone that Japan’s economy can’t recover until the banks are again strong and viable lenders.