Japan's Banks Get Another Mr. Fix-It

Heizo Takenaka says he wants to speed reform. Can he?

Is Japan ready for real bank and economic reform? Japan critics impatient for that process to get under way were encouraged when Prime Minister Junichiro Koizumi sacked his top bank regulator Sept. 30 and handed the job to his reform-minded chief economic adviser, Heizo Takenaka. Takenaka also kept his job overseeing broader economic reform, making him the country's new workout czar.

O.K., cabinet shuffles in Japan are as common as singalongs in karaoke bars. Why's this one different? Because Takenaka, 51, a soft spoken, witty former economics professor at Keio University and Harvard, has made clear he regards the situation of Japan's banks and larger economy with the same alarm as a lot of outsiders. Just hours after his promotion, Takenaka signaled a big policy shift by declaring that Japan's financial system is "gravely ill and needing treatment." By contrast, his ousted predecessor as head of the watchdog Financial Services Agency, Hakuo Yanagisawa, insisted time and again, against all evidence, that Japanese banks were just fine, thank you.

Takenaka has already taken some quick steps to speed up a reform process that has been poking along at a snail's pace for ten years. He is naming a task force to take a new look at fixing the banks: In two weeks he wants a plan to kick start the workout of banks' bad loans. One sign of Takenaka's seriousness is a report that he will appoint Takeshi Kimura, a former Bank of Japan official, to that group. Kimura, currently president of KPMG Financial Inc. in Japan, kicked up a storm last year by backing aggressive write-offs of soured loans at banks to boost competitiveness in the economy, even if that forces borrowers into bankruptcy.

Takenaka is also likely to order a new round of audits of the big banks' loan portfolios to flush out more duds on their books. Such a hard-edged audit would force lenders to set aside provisions more aggressively. Yanagisawa (and Koizumi) have maintained that the lion's share of Japan's nonperforming loans, officially estimated at $430 billion, could be mopped up by 2004 without a taxpayer-funded bailout. Takenaka and others say the total of nonperforming and questionable loans is much higher, maybe even as much as $1.1 trillion. That's why earlier this year Takenaka broke with protocol and criticized Yanagisawa for the alleged lax quality of his audits. In that quarrel, Takenaka got the backing of the Bank of Japan.

This is the kind of tough talk Western policymakers like. "It's a very good signal that [he] was chosen," said White House economist and Council of Economic Advisers Chairman R. Glenn Hubbard. "I've known him for some time and he's very committed to reform."

The question now is what kind of reform. In the medium term, Takenaka has to figure out whether the banks need an infusion of public cash to cushion their capital base. Yanagisawa insisted no such bailout was necessary. Indeed, he warned in a speech on the day he got the ax that throwing more money at the problem would just blunt any restructuring effort the banks are trying themselves. One Japanese bank president agrees, arguing that "injecting vast amounts of government money would ease the pressure" to reform.

That's a plausible line to take--especially since an $80 billion bailout of the banks in 1998-99 was an abject failure--but only if you buy into the idea that the banks are making serious headway on their own. Skeptics such as Takenaka and BOJ Governor Masaru Hayami think some Japanese banks are actually trapped in a downward spiral. Japan's toxic brew of weak corporate earnings, deflation, and collapsing land prices means that banks are stuck on a treadmill in which new loans go bad as fast as they write off old ones. On top of that, with the Nikkei stock index off some 15% in the fiscal half ended Sept. 30, banks have just suffered an estimated $28 billion loss on their massive stock holdings in Corporate Japan. Part of that total must be subtracted from their capital base.

To give them their due, Japanese banks have written off a staggering $672 billion in bad loans since Japan's recession began in 1990--but none of this has improved their financial condition. Official numbers on the ratio of nonperforming loans to total loans today is 7% to 8%, but private analysts put the real number at 10% to 15%, compared with 2% to 3% in the U.S. and Western Europe. Many of the written-off loans involved the first casualties--real estate speculators and nonbank finance companies--of the collapse of Japan's bubble economy. But now, after three years of price deflation, the bad loan problem has widened to include big retailing and construction companies such as Mycal Group, which collapsed last year, and Daiei and Daikyo, which have hit up their lenders to restructure and forgive their debt.

In other words, a newer, possibly deadlier loan crisis has emerged. What really worries economists at the International Monetary Fund and in the Bush Administration is that on top of the $430 billion in nonperforming loans that regulators acknowledge, some $845 billion of loans are on the list of credits that officials say need special scrutiny. A recent report from Standard & Poor's says that as much as $162 billion of that pool could go sour if the economy goes back into recession, and land prices keep falling, as they have done since 1992. "Losses of this magnitude represent four years of net operating profit for Japan's entire banking industry," says analyst Naoko Nemoto, one of the authors of the report.

If Nemoto is right, the banks are going to need lots of help. That means, says White House economist Hubbard, "that public money will have to be used."

If so, funds could be injected directly into the banks. In that case, Takenaka might stipulate that the banks generate acceptable returns: If they fail, the FSA would install new managers. Another approach would involve beefing up the capital base of the state-run Resolution & Collection Corp., which has already been paying banks discounted prices for their bad loans.

Takenaka definitely has the right idea, but he will need to master the art of political infighting to get a banking package through the Diet. Koizumi may or may not be willing to deploy his much-improved public approval rating to stand behind Takenaka in a painful and expensive bank overhaul. "Remember, if there is a lender, there is also a borrower," says Masao Hirano, director of McKinsey & Co. Japan. And workers for those borrowers in the construction and retailing industries tend to vote for Koizumi's Liberal Democratic Party. So do employees of the small and middle-size companies that represent 60% of the outstanding loans in Japan. One chilling lesson for Takenaka: Yanagisawa himself was once seen as reform's best hope. But in the end, the system won. Good luck, Takenaka-san.

By Brian Bremner in Tokyo, with Rich Miller in Washington

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