Japan's Banking Crisis: How Similar to Ours?

Japan’s Nikkei stock index peaked near 40,000 in 1989.  But a year later, it had dropped 43% (see the chart, left).  And as Japan entered the 1990's, a crisis began to emerge in its financial system, a crisis that lasted for years and resulted in the failure of several major banks.  Many people believe this was one of the worst banking crises in history, generating an incredible $700 billion of losses, a number eerily similar to the current bail out amount proposed by Paulson and the US Congress.  So what happened during Japan's crisis and how did the experience compare with the crisis underway in America today?

In researching for this event, the first thing I checked was interest rates set by the Central Bank of Japan.  In the late 1980's, these were lowered successively until they reached 2.5%, at that time a very low rate for Japan.  During 1988 and 1989, inflation was running 2.5 to 3.0%, so real interest rates at the end of the 80's were near zero, or slightly negative.  The ultimate cause of the crisis?  Looking back, most experts agree that it was excessive risk taking on the part of banks, that filtered throughout the economy.  A combination of declining profit margins, deregulation, and weak regulation of banks led to i) over-aggressive economic expansion, ii) credit liberalization, and iii) inflated asset valuations.  At that time, reserve requirements in Japan were 4% for domestic banks, and 8% for banks with foreign operations.

In short, Japan's crisis was caused by derugulation and declining profit margins, which led to increased competition between banks and increased risk -taking.  This was true in both consumer credit and in the real estate industry.  It all sounds incredibly similar to the scenario that is playing out across America today.

Japan's financial crisis took an entire decade to play out and it happened as follows:

1989-90:  The stock market peaked in 1989, then collapsed in 1990, dropping an incredible 43%.  Over the next three years, it experienced high volatility, but the general trend was downward. 

1992: Land prices begin a steep decline and defaults begin rising on consumer loans. 

1993: Problem loans were making life difficult for many institutions and Japanese banks established the CCPC, Cooperative Credit Purchasing Company, to purchase non-performing loans and get them off balance sheets. Some banks tried restructuring "problem loans" by lowering interest rates and extending maturities in an attempt to delay the inevitable.

1995:  Residential and commercial property values continued to decline and take down a major residential mortgage lender.  I found one study which recorded that real estate prices, on average, dropped 80% from 1991 and 1998, although other data seemed to indicate a lower number. 

1997:  Many banks were experiencing negative return on equity.  And they kept paying dividends even though they needed more capital.  Making matters worse, the government had yet to intervene in a meaningful way, as it expected the economy to turn around. In April 1997, Nissan Life goes bankrupt, Sanyo Securities defaults on borrowings, and two other major banks suspend operations. 

1998:  The crisis peaks.  The government authorizes a 30 trillion yen bail out for banks and depositors, but a credit crunch ensues anyway as banks become more restrictive on lending to preserve capital.   The Long Term Credit Bank of Japan, a major lender, is nationalized.  This is followed by a wave of bank mergers over the next two years.

Post Crisis:  Consumers must reduce consumption significantly, as there is less credit available.  Unemployment increases and GDP growth slows.  From "start to finish" the problems in the financial sector took over 10 years to play out. 

The situation seems to have many similarities to what is underway ion the US.  To date, the domestic financial crisis is not as bad as Japan's and not as bad as the S&L Crisis of the late 80's.  Between 1989 and 1991, it has been reported that 1,187 banks and S& L’s failed, consisting of more than $454 billion in assets.  This was according to the Federal Deposit Insurance Corporation.  So far in 2008, there have been 11 bank failures.   These represent total assets of around $40 billion.  but it is my opinion that the crisis is still in its early stages and the the US government has acted moire swiftly, taking a cue from Japan's crisis.  But I think it will be years, perhaps 2010 or later, until the US problems play out to their conclusion.

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