How Japan Restored Its Financial System - The focus was on better risk controls, not higher capital reserves

How Japan Restored Its Financial System. By KATSUNORI NAGAYASU
The focus was on better risk controls, not higher capital reserves.
WSJ, Aug 06, 2009

Regulatory authorities around the world are currently discussing ways to prevent another financial crisis. One idea is to mandate higher levels of capital reserves. Japan’s banking reform shows that a comprehensive solution would work better.

After our bubble economy collapsed in the 1990s, it took policy makers many years to address the real issue: the health of our financial system. When they did, they injected public funds into large Japanese banks across the board, enhanced deposit insurance safety nets, and accelerated the disposal of nonperforming assets based on strict risk assessments. The market selected which banks could survive under a system of multiple regulatory requirements, not just a capital requirement. Many banks were absorbed into larger entities.

Japan also avoided moral hazard by studiously avoiding the classification of any bank as “too big to fail.” Regulators instead put more emphasis on improving banks’ risk controls and did not require them to have excess capital. The financial system soon regained its health and the economy enjoyed seven consecutive years of uninterrupted growth, starting in 2001.

Today’s regulatory dialogue in the United States and Europe has implicitly assumed that large financial institutions are “too big to fail.” This assumption may encourage banks to take excessive risks, resulting in potentially more bank bailouts. It has also skewed the regulatory debate toward a focus on requiring banks to hold higher levels of “going concern capital,” such as common equity.

This is a dangerous path to follow. If regulators mandate higher capital requirements for banks, there is no guarantee that banks will be able to raise that capital in equity markets. They may have to shrink their balance sheets to meet the requirements, potentially curtailing their capacity to lend and support economic growth. A narrowly defined approach to capital regulation would also reduce banks’ options for raising other types of capital when they need it. This could result in systemic risk when another financial crisis hits.

A better regulatory framework must combine capital regulations with other tools, including a resolution mechanism for financial institutions that fail, a retail deposit insurance system, and a prompt corrective action system that allows regulators to force a bank to take action before it fails. As long as the regulators can effectively control systemic risk by taking such a multifaceted approach, banks should also be allowed to absorb losses, raising capital other than common equity. It should be acceptable to allow banks to fail, and there should be no need for excessive capital requirements.

A new regulatory framework must also distinguish between banks whose main business is deposit taking and lending—the vast majority of banks world-wide—and banks that trade for their own account. The recent financial crisis demonstrated that balance sheet structure matters. Trusted banks with a large retail deposit base continued to provide funds to customers even in the depths of the crisis, whereas many banks that relied heavily on market funding or largely trading for their own account effectively failed. Investment banks with higher risk businesses by nature should be charged a higher level of capital requirement—otherwise, sound banking will not be rewarded.

Higher capital requirements attempt to rectify market or systemic failure by denying the market mechanism, where banks that take too much risk fail, and those that don’t, survive. Excessive regulation will stifle healthy competition in banking.

Policy makers instead should learn from Japan’s experience by improving the range of regulatory rules available and setting reasonable capital rules for banks based on their actual business models. That’s the best way to ensure banks perform their essential role at the lowest long-term cost to taxpayers, customers and shareholders.

Mr. Nagayasu is president of Bank of Tokyo-Mitsubishi UFJ and chairman of the Japanese Bankers Association.