Column  International Exchange  2012.03.28

-The Ongoing Economic Crisis- Series 3: The mistakes of US authorities in dealing with the financial crisis

Newsletter from Daisuke KOTEGAWA

The next problem involves the process of bailing out financial institutions. US authorities bailed out banks by injecting public money in order to defend the financial system. In light of our experience in Japan, there are two problems with regard to the modality of the bailout in the United States.

First, it has not cleared doubts about the health of the balance sheets of financial institutions. The following measures are essential for clearing concerns in light of our experience:

(i) The balance sheets of all major financial institutions must be examined by an official authority, using mark-to-market accounting, and the results must be made public;

(ii) The amount of public funds necessary to completely dispose of non-performing loans in each institution must be identified;

(iii) Each institution must dispose of all non-performing loans, making it clear that no non-performing loans are left on balance sheets to market investors.

This is well proven by the fact that public money in the amount of 1.8 trillion yen injected on March 1998 without the authorities' prior examination of institutional balance sheets failed to wipe out market concerns about Japanese financial institutions, while another injection in the amount of 7.5 trillion yen on March 1999, only after authorities, applying mark-to-market accounting, examined institutional balance sheets, was successful. The first injection was done across-the-board using the same amounts, while the second was not across-the-board and used different amounts. It was also made clear who actually bore the burden of the loss caused by non-performing loans. In the case of Japan, the total amount of disposed debt reached 100 trillion yen, of which only 10 trillion yen was borne by the public; the rest was absorbed into the annual profits of private financial institutions. I have emphasized this point since presenting it at Harvard Business School in the spring of 2008.

In the United States, the mark-to-market accounting rule was frozen until the fall of 2010 as a result of pressure by the US Congress over AICPA (American Institute of Certified Public Accountants). The method of examining balance sheets of major financial institutions is not stringent, unlike in Japan where loan loss reserves are computed against individual transactions. It is called a "Stress Test", which is built around computations based on macroeconomic forecasting. Moreover, according to banking staff who were in charge of this test, the bare results of the test horrified authorities, who then allowed the final results to be adjusted. It will be difficult for the market to regain confidence in the balance sheets of major financial institutions in the United States. The injection of public money following the stress test fell short of assuring investors that the amount injected was enough to dispose of non-performing loans at these major financial institutions.

Furthermore, the stress test applied more stringent loan loss reserves to securitized products at the center of the problem than those built up by individual financial institutions. Reserve levels are not sufficient in light of our experience in Japan. Discount rates on non-performing loans in Japan, most of which used real estate as collateral, reached upwards of 90%. Discount rates on securitized products which do not have such collateral must be higher. Actual discount rates upon which the amount of loan loss reserves is calculated are far lower, far short of the level that would restore the market's confidence in the health of financial institutions. Such a low level of loan loss reserves being what they are on the asset side, practices on the liability side are simply horrifying. Securitized products posted on the liability side - that is, those created by one institution and sold to another - have been deeply discounted on the grounds that, as there is no market for such products, they can buy them back at a high discount, resulting in a substantial reduction of liabilities. Substantial bonuses have been paid out of the net profit created by such treatment. I would like to reiterate that it will be difficult to wipe out uncertainties about the health of financial institutions without an ample injection of public money based on a diligent examination of balance sheets by authorities and then making them public.

The second problem lies in the fact that public money was injected without investigating the responsibility of bank management and authorities. As you can easily recall, all board members of liquidated or partially nationalized financial institutions during the Japanese financial crisis in 1997 and 1998, such as Sanyo Securities, Yamaichi Securities, Long-Term Credit Bank and Nippon Credit Bank, were arrested and prosecuted, except those of Sanyo Securities. Several staff of supervisory authorities, including the Ministry of Finance and the Bank of Japan, were also arrested and found guilty. Some of them committed suicide. Executives of Long-Term Credit Bank and Nippon Credit Bank were found innocent by the Supreme Court more than ten years later. It is arguable whether such prosecutions were appropriate. In this way, however, the responsibility of bank executives and supervisors was tested through the judicial process. In contrast, the responsibility of those people has never been tested in the United States. It is worthwhile to keep in mind the magnitude of the political influence of financial institutions, in particular that of Wall Street. In the case of Japan, criticism mounted, thus reducing their political influence, following scandals over the behavior of financial institutions and supervisory authorities, the liquidation of major institutions, and the prosecution of key people. In the case of the United States, the all major financial institutions avoided liquidation except Lehman Brothers, kept intact through a bailout and their political clout. This situation made it difficult not only to launch fundamental reforms of the financial system, but to fully investigate the real cause of the financial crisis. In particular it has made it extremely difficult to investigate the responsibility of executives of major banks. Bailing out major banks without prosecuting their executives fostered disbelief in the political process; voters do not know where to direct their anger over how tax revenue paid by honest taxpayers can be justifiably used to bail out major banks, whose executives brought about the ongoing financial crisis, received excessive bonus, and escaped prosecution without being brought to account. As a result, top executives of major banks in the United States have not learned any lessons from the Lehman crisis. It is frightening to think that such executives are likely to make the same mistakes again.