Sayonara Japan, Hello America!

After Geithner’s earnest declaration that “we are not Sweden” I felt compelled to go back and read through the details of past banking crises just to see what makes us so different. Following which, I fear our Treasury Secretary will have to make a bit more effort to convince me how we are going to avoid becoming Japan.

The parallels have been drawn many a time, including in a fairly recent NBER paper, whose eerie timeline of Japan's steps to resurrect the financial sector left me wondering: Is it short memory, self-denial, inflated egos or what, that’s driving our own policymakers into trying to reinvent the wheel?

I’m not going to go through Japan’s measures one by one (I strongly recommend reading the NBER paper for that). I want to focus instead on how to avoid repeating Japan’s mistakes in dealing with banks' undercapitalization problem. So here we go:

What to aim for: Let’s start with a vision… One of the most interesting parts of the paper (for me) is its discussion of the Japanese authorities’ disregard of evidence of “overbanking” and a need for consolidation in the sector.

“Instead, the only objective that was pursued forcefully as part of the recapitalization was that banks were required to increase their lending, especially to small and medium firms. The recapitalized banks were required to report the amount of loans to small and medium firms every six months.”

The parallel with the US is clear: The US approach up till now has lacked a vision with regard to the desirable size and structure of the banking system. If anything, the authorities plan to make it bigger by providing subsidized leverage to what would effectively be new “banks,” while “old” banks unload their burdens so that they can go ahead and… lend more.

Some have countered that before you get to repair the Titanic, you have to prevent it from sinking. Maybe. But to take the analogy further, to me it looks like we are wasting our efforts unloading our “family gold” into the ocean, instead of employing some of our limited resources to plug the holes.

Put it differently, (and as in Japan), the rescue efforts have been (and are being) applied to all institutions indiscriminately, without careful auditing to assess each financial institution’s health or the outlook of its future viability.

Think of the Treasury’s Capital Assistance Program, which applied to the “selected” institutions on a mandatory basis, needed or not; or the PPIP which is designed to benefit whichever bank has assets for sale, regardless of whether some banks may eventually have to fail. Not to mention the billions already wasted on AIG.

If the current course of action were to continue, the outcome would look like this: A recapitalization that is too small to solve the problem; yet too large by any standard of social equity and fairness. A banking sector that is too large to be sustainable without meaningful consolidation. And a bunch of carcasses left in banks’ books, as banks eagerly wait for a turnaround in the markets to lift asset prices and help them close their (true) capital hole. Japan all over.

Here is a better approach, building on the Japanese experience:

Step 1: “In Japan the recovery started with the toughening of the regulatory audits.”

Frankly, I don’t see (the substance of) why the authorities have been resisting conducting an evaluation of banks’ health on a mark-to-market basis. The taxpayer is in with his wallet either way, whether it’s in the form of new bank capital or of subsidized funding to private participants in the PPIP, TALF, etc.

But still. The point is that we need a consistent and transparent process to estimate the size of the capital gap in each bank. If mark-to-market is a non-starter, the estimates could be based on the valuations of the so-called “Third Party Valuation Firms”, i.e. the entities used by the Treasury to assign preliminary prices for the pools of assets banks put for sale under the PPIP.

(Incidentally, I don't think the stress tests can do the job, and you can see here why. Neither will the PPIP, but I’ll have to discuss why in another post).

Step 2: “[..] the 1999 recapitalization, together with the introduction of a scheme for orderly closure of systemically important banks through nationalization in 1998, ended the acute phase of the banking crisis.” (my emphasis)

Just to clarify, this is not (necessarily) a call for nationalization, but… For me, one of the most positive developments coming out of the Treasury has been the government’s request for authority to take over systemically important financial institutions at the brink of default (see here). If granted, it could be a powerful tool in helping execute the government’s vision (to the extent they develop one) as to the desirable/feasible size of the banking system, by allowing the (orderly) wind-downs of weak institutions, including systemic ones.

Step 3: “One important ingredient were the changes initiated in late 2002 and early 2003 at the behest of Heizo Takenaka, who […] called for (1) more rigorous evaluation of bank assets, (2) increasing bank capital, and (3) strengthening governance for recapitalized banks” (my emphasis)

The Administration’s attitude towards bank governance has been gentle at best; yet it should be a core element of a comprehensive bank strategy. I continue the quote:

“In August 2003, the FSA also issued business improvement orders to fifteen recapitalized banks and financial groups, including five major ones (Mizuho, UFJ, Mitsui Sumitomo, Mitsui Trust, and Sumitomo Trust) for failing to meet their profit goals for March 2003. They were required to file business improvement plans and report their progress each quarter to the FSA.

UFJ Holdings was found to have failed to comply with its revised plan in March 2004 and received another business improvement order. The CEOs of UFJ Holdings, UFJ Bank, and UFJ Trust were forced to resign, and the salaries for the new top management were suspended. The dividend payments (including those on preferred shares) were stopped. Salaries for the other directors were cut by 50%, their bonus had already been suspended, and the retirement contributions for the management were also suspended. The number of regular employees was reduced and their bonuses were cut by 80%.”

I am personally encouraged by the Administration’s decision to take a tougher line on GM and I can only hope that it adopts a similar approach towards banks—involving changes in banks’ management and the requirement for business restructuring and viability plans.

As a concluding note, here is another quote from the paper:

“The main problem with the Japanese approach was that the banks were kept in business for far too long with insufficient capital. This limited the banks willingness to recognize losses and they took extraordinary steps to cover up their condition and in doing so retarded growth in Japan. The U.S. policymakers seem to appreciate that this was extremely costly and appear to be trying to avoid it.”

Let’s hope that America's efforts to avoid Japan's mistakes go beyond “appearances,” because the similarities are too scary to allow us to imagine a different outcome.