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Will the U.S. Bank Recapitalization Succeed? Lessons from Japan Takeo Hoshi Anil K Kashyap Jacquemin seminar European Commission June 18, 2009 1.

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Presentation on theme: "Will the U.S. Bank Recapitalization Succeed? Lessons from Japan Takeo Hoshi Anil K Kashyap Jacquemin seminar European Commission June 18, 2009 1."— Presentation transcript:

1 Will the U.S. Bank Recapitalization Succeed? Lessons from Japan Takeo Hoshi Anil K Kashyap Jacquemin seminar European Commission June 18, 2009 1

2 Outline 2 1.Similarities between the U.S. and Japan 1997- 1999 in Japan = Fall 2008-2009 in the U.S. 2.Lessons from the Japanese asset purchase and capital injection experience 3.Analysis of bank capital rebuilding in Japan

3 Contributions 3 1.Concise overview of the Japanese experience 2.Some new analysis, especially on what finally ended the capital shortage in Japan and the adverse effects of directed credit 3.Highlight a number of policies experimented with in the U.S. that failed in Japan

4 4

5 Mar. 2008 to Feb. 2009 in the U.S. Unexpected failure of large institutions (Mar and Sep 2008) Spike in the interbank borrowing rate, sharp rise in the cost of insuring debts, frozen capital markets Call for suspending mark-to-market accounting, restriction on short sales (Sep 2008) Original TARP (Oct 3, 2008) Capital Purchase Program (Oct 14, 2008) Republicans lost big, new President chosen (Nov 2008) 2 nd capital injections to Citigroup, Bank of America Freefall of bank stock prices Geithner Plan (From Feb 2009): Stress tests, capital assistance, PPIP, expansion of TALF 5

6 Nov. 1997 to Mar. 1999 in Japan (Chapter 8 of Hoshi and Kashyap 2001) Unexpected failure of large institutions (Nov 1997) Spike in the interbank borrowing rate New accounting to cover up problems (Jan 1998) Half-hearted recapitalization (Mar 1998) – All banks get the same injection = amount desired by the strongest bank LDP loses election, government resigns (June 1998) Second round crisis legislation (Oct 1998) Several major financial firms nationalized (Nov 1998) Second round recapitalization (Mar 1999) – MOF official declares crisis will be over in 2 weeks (Feb 1999) 6

7 7 Chronology of Japanese experience 1.Late 1997-early 1999: classic credit crunch 2.1999 to 2003: bank capital shortage and raging zombie problem 3.2003 to 2007: bank capital rebuilding and economic recovery

8 Japan Premium: 1995-1999 (bp) 8

9 9 1998 Capital Injections Preferred SharesSubordinated loans/debts S&P Rating Total Funds TypeAmount dividend rate Conversion start Forced conversion TypeAmount yield for 5 years yield after 6th year City banks Dai-ichi KangyoBBB+99CPS990.757/1/19988/1/2005 FujiBBB+100SDP100L+1.10L+2.60 SakuraBBB100SDP100L+1.20L+2.70 SanwaA-100SD10100L+0.55L+1.25 SumitomoA-100SDP100L+0.90L+2.40 Tokyo MitsubishiA100SDP100L+0.90L+2.40 AsahiBBB+100SLP100L+1.00L+2.50 DaiwaBBB-100SLP100L+2.70 TokaiBBB+100SDP100L+0.90L+2.40 Long-term Credit bank Ind. Bank of JapanA-100SD10100L+0.55L+1.25 LTCBBBB-177.6CPS1301.0010/1/19984/1/2008SLP46.6L+2.45L+3.95 Nippon Credit BankNR60CPS601.0010/1/19984/1/2018 Trust banks Mitsubishi TrustA-50SDP50L+1.10L+2.60 Sumitomo TrustA-100SDP100L+1.10L+2.60 Mitsui TrustBBB+100SDP100L+1.45L+2.95 Chuo TrustNR60CPS322.507/1/19988/1/2018SLP28L+2.45L+3.95 Toyo TrustNR50SDP50L+1.10L+2.60 Regional Bank Bank of YokohamaBBB20SLP20L+1.10L+2.60 Hokuriku BankNR20SLP20L+2.45L+3.95 Ashikaga BankNR30SDP30L+2.95L+4.45

10 1997/98 Capital Shortage and Credit Crunch in Japan BoJ minutes Tankan survey data Mix between CP and bank lending Regression evidence 10

11 Bank of Japan January 1998 minutes: Members noted that the current phase of the economy featured (1) a substantial decline in private consumption, ……; (2) a significant deterioration of confidence in the economic outlook ……, leading to amplified concern about the economy; and (3) a vicious circle created by interaction between the real economy and financial activity …… The minutes go on to report that the prospects for a more restrictive lending attitude of financial institutions and its possible effects were discussed in detail. (emphasis in the original). 11 FOMC Oct 29, 2008 meeting: [FOMC] Participants were concerned that the negative spiral in which financial strains lead to weaker spending, which in turn leads to higher loan losses and a further deterioration in financial conditions, could persist for a while longer.

12 12 Accommodative Tight

13 13

14 14 March 1999 injectionsPreferred sharesSubordinated debt/loans S&P Rating TotalTypeAmt div. rate Conversion start date Forced conversion TypeAmtyield after step-up step-up date Dai-ichi KangyoBBB900CPS2000.418/1/20048/1/2006SD10100L+0.75L+1.254/1/2004 CPS2000.708/1/20058/1/2008SD11100L+0.75L+1.254/1/2005 NCPS3002.38 FujiBBB+1,000CPS2500.4010/1/20042/1/2009SDP200L+0.65 L+1.35 L+2.15 4/1/2004 4/1/2009 CPS2500.5510/1/20062/1/2011 NCPS3002.10 SakuraBBB800CPS8001.3710/1/200210/1/2009 SanwaBBB+700CPS6000.537/1/20018/1/2008SDP100L+0.34L+1.3410/1/2004 SumitomoBBB+501CPS2010.355/1/20022/27/2009 CPS3000.958/1/20052/27/2009 AsahiBBB+500CPS3001.157/1/200212/1/2009SLP100L+1.04L+2.544/1/2009 CPS1001.487/1/200312/1/2014 DaiwaBB+408CPS4081.066/30/19994/1/2009 TokaiBBB-600CPS3000.937/1/20023/31/2009 CPS3000.977/1/20033/31/2009 Industrial Bank of Japan BBB+600CPS1750.437/1/20039/1/2009SDP250L+0.98L+1.484/1/2004 CPS1751.409/1/20039/1/2009 Mitsubishi TrustBBB300CPS2000.817/31/20038/1/2008SDP100L+1.75L+2.254/1/2004 Sumitomo TrustBBB200CPS1000.764/1/20013/31/2009SD12100L+1.53L+2.034/1/2006 Mitsui TrustBBB-400CPS250.31.257/1/19998/1/2009SLP150L+1.49L+1.993/31/2004 Chuo TrustNR150CPS1500.907/1/19998/1/2009 Toyo TrustNR200CPS2001.157/1/19998/1/2009 Bank of YokohamaBBB200CPS701.138/1/20017/31/2009SDP50L+1.65L+2.154/1/2004 CPS301.898/1/20047/31/2009SL1050L+1.07L+1.574/1/2004

15 Cross-section regression of new loan growth on capital ratio 15 YearReported capital ratioAdjusted capital ratio 1995.0047 (.0055).0010 (.0026) 1996.0148 (.0070) **.0104 (.0045) ** 1997.0023 (.0038).0026 (.0025) 1998.0168 (.0039) ***.0156 (.0028) *** 1999.0073 (.0053).0119 (.0030) *** 2000.0201 (.0080) **.0177 (.0074) ** 2001.0014 (.0013).0011 (.0012) 2002.0007 (.0036).0034 (.0019) * 2003-.0046 (.0046)-.0042 (.0042) 2004-.0028 (.0040)-.0027 (.0039) 2005-.0022 (.0033)-.0017 (.0030)

16 16 Non-Performing Loans (Risk Management Loans): 1996-2008 (100 million yen)

17 How big was the problem in Japan? (All banks, ¥ billion) 17 End ofLoan LossesCumulative Loan Losses since 4/1992 Number of Major Banks 3/19943.8725.512 21 3/19955.23210.744 21 3/199613.36924.113 20 3/19977.76331.877 20 3/199813.25845.135 20 3/199913.63158.766 17 3/20006.94465.710 18 3/20016.10871.818 18 3/20029.72281.540 15 3/20036.65888.198 13 3/20045.37493.572 13 3/20052.84896.420 13 3/20060.36396.783 11 3/20071.04697.829 11 3/20081.12498.953 11 19% of GDP

18 Economic fallout post-1998 Banks gambling for reclamation through rolling over loans – Government pressure to lend especially to SMEs Zombie firms continuing receive credit Productivity slowdown in zombie infested sectors 18

19 19 Independent variable YearLag 1Lag 4YearLag1Lag4 Real estate loan1998.348 (.083).312 (.065) 2002.242 (.079).213 (.069) SMC loan.038 (.026).027 (.021).111 (.024).062 (.032) Real estate loan1999.653 (.174).684 (.165) 2003.141 (.056).134 (.059) SMC loan -.021 (.041) -.051 (.053).108 (.018).083 (.019) Real estate loan2000 1.534 (.573) 1.132 (.553) 2004.009 (.044).045 (.048) SMC loan -.082 (.114) -.029 (.108).101 (.014).097 (.017) Real estate loan2001.430 (.164).388 (.233) 2005.006 (.054) -.039 (.054) SMC loan.201 (.083).075 (.041).066 (.017).085 (.018) Cross-section regression of NPL ratio

20 20 YearLag 1Lag 2Lag3Lag4 2001-.1070 (.0521) -.0437 (.0260) -.0452 (.0256) -.0465 (.0264) 2002-.0213 (.0240) -.0128 (.0218) -.0079 (.0130) -.0107 (.0142) 2003-.0085 (.0052) -.0072 (.0056) -.0049 (.0058) -.0038 (.0054) 2004-.0158 (.0054) -.0142 (.0043) -.0083 (.0034) -.0126 (.0054) 2005-.0107 (.0044) -.0115 (.0037) -.0113 (.0036) -.0067 (.0033) Cross-section regression of bank profit rate on SME loans

21 21 Total Factor Productivity by Industry: 1980-2002 (1995=100 )

22 Overview of the Responses Strategies adopted 1.Asset management companies 2.Liquidation of Jusen 3.Protection of bank liabilities 4.Capital injections 5.Temporary nationalization of insolvent but systemic important banks 6.Takenaka plan (Fiscal cost) 22

23 NameDates (purchases) Target PurchasesAmount Spent (¥ Trillion) Amount Collected (¥ Trillion) Comments Cooperative Credit Purchasing Co. (CCPC) 12/1992- 3/2001 Non-performing loans with land collateral of contributing banks 5.8 (market ) [=15.4 book] Bank financed, created tax benefits by buying loans Liquidated in 3/2004 Tokyo Kyodo Bank1/1995- 4/1999 Initially assets of failed credit unions, later assets of any failed banks 4.7185.362Reorganized as Resolution and Collection Bank (RCB) in 9/1996 Housing Loan and Administration Corp. (HLAC) 7/1996- 4/1999 Loans of failed jusen (specialty housing loan companies) 4.656 (market)3.233Financed with mix of public and private money Resolution and Collection Corp. 4/1999- 6/2005 Combined RCB and HLAC, mandate extended to allow purchases of assets from solvent banks 0.356 (market) [=4.046 book] (beyond earlier HLAC and RCB spending) 0.649 Starting in 2001 also reorganized loans, ultimately involved in restructuring 577 borrowers Industrial Revitalization Corp. of Japan 5/2003- 3/2005 Buy non-performing loans through 2005, restructure them within 3 years 0.53(market) [=0.97(book)] NA [0.094 surplus as of 5/2007] Restructured 41 borrowers with 4 trillion total debt Closed in 5/2007 1. Asset Management Companies 23

24 24 2. Jusen (background) Specialized housing finance companies created in the 1970s to provide mortgage financing In the 1980s, banks (founders of jūsen) started to enter home mortgage business as they started to lose their traditional customers to capital market Jūsen started to lend more to real estate developers Land price boom intensified the trend Increasing fund coming from agricultural coops Non-performing loans of ¥4.6 trillion (38% of total loans) in 1991

25 25 2. Liquidation of jusen Government led (optimistic) restructuring plans in 1991 and 1993 failed By 1995, 75% of loans non-performing (60% completely unrecoverable), leverage > 150 Write-off of ¥6.41 trillion (¥3.50 trillion by the founder institutions; ¥0.53 trillion by the agricultural coops; ¥1.70 trillion by the other lenders; ¥0.68 trillion by the taxpayers) The remaining assets (¥6.6 trillion) transferred to Jūsen Resolution Corporation Public anger over the taxpayer cost led to politicians to tread slowly in subsequent bailouts

26 26 3. Full protection of bank liabilities 1996¥10 million limit on deposit insurance (per account) was lifted (to expire on 03/2001) 1997(Nov.) BOJ and MOF reiterated the full protection of deposits and announced security of interbank loans 1998 Bank liabilities were protected when LTCB and NCB were nationalized 2000Expiration date of the assistance that exceeds the pay-off costs moved to 03/2002

27 27 5. Temporary nationalization Financial Reconstruction Act of 1998 Weak banks were allowed to apply for nationalization Long-term Credit Bank asked to be nationalized (Oct 1998) approved FRC forced nationalization of Nippon Credit Bank (Dec 1998) Several failed regional banks put under receivership (1999-2001)

28 Date Official Core capital Deferred Tax Assets Estimated Under- reserving Modified Capital Capital held by govt Bank Assets Capital Gap ABCD=A-B-CEFG=0.03*F-D Mar-9627.90.0NA27.90.0846.5-2.5 Mar-9728.50.015.013.50.0856.012.2 Mar-9824.30.04.919.40.3848.06.0 Mar-9933.78.44.021.36.3759.71.5 Mar-0035.68.25.821.66.9737.20.5 Mar-0137.67.17.523.07.1804.31.1 Mar-0230.210.66.812.87.2756.19.9 Mar-0324.810.65.48.87.3746.313.6 Mar-0429.07.25.716.18.9746.76.3 Mar-0531.45.76.918.88.1745.93.6 Mar-0637.32.38.326.75.2766.9-3.7 Mar-0740.01.39.429.43.5761.1-6.5 Mar-0834.83.610.221.03.1780.72.4 28 Crude evidence on forbearance

29 1.Have banks make more rigorous evaluation of assets using discounted expected cash flows or market prices of non- performing loans 2.Check cross-bank consistency in classifying loans to large debtors 3.Publicize the discrepancy between the banks self evaluations and the FSAs evaluations 4.Be prepared to inject public funds if necessary 5.Prohibit banks from declaring unrealistically large deferred tax assets 6.Impose business improvement orders for banks that substantially underachieved the revitalization plans. Takenaka Plan 29

30 30 Capital Evolution for Japanese Banks 2003 to 2007 (¥ trillion) March-07March-03Change Percent contribution to change Official Capital40.024.815.2100.00% Common stock9.310.2-0.9-6.13% Capital surplus8.78.60.10.39% Retained earnings13.44.49.059.07% Net unrealized gains on stocks and others8.20.18.153.25% Revaluation reserve for land1.01.5-0.6-3.70% Net deferred gains on hedging instruments-0.30 -2.07% Note: Some small components have been omitted and because of this and rounding columns may not sum to totals.

31 31 Cumulative (3/04-7/03) March- 07 March- 06 March -05 March -04 March -03 Difference (3/07-3/04) Net income8.13.44.21.3-0.84.2 Operating profits11.54.34.81.90.5 Extraordinary profits - Extraordinary losses 2.80.41.20.70.5 Operating income19.218.016.917.61.6 Operating expenses14.913.315.017.0-2.2 Unrealized capital gains8.26.83.73.1 Nikkei 22517,28717,05911,68811,7157,973 GDP growth (% change from one year earlier) 1.72.52.42.02.1 Profit Decomposition for Japanese Banks 2004-2007 (¥ trillion)

32 Japans eventual macroeconomic recovery 32

33 33 Export-led recovery (contributions to growth, %)

34 AssistanceRecovery Monetary grants18,868 Assets purchase9,7789,672 Capital injection12,42710,539 Others5,9954,861 Total47,06825,072 Fiscal Cost (FDIC financial assistance and recovery, Sept. 2008, ¥ billion) 34 Net : ¥21,996 billion Jusen resolution: ¥ 680 billion Loss compensation for RCC: ¥ 292 billion Total: gross ¥48,040 billion (about 9.6% of GDP) net ¥22,968 billion (about 4.6% of GDP)

35 Lessons 1.Banks may refuse public funds (fear of signaling troubled situation; creation of claims senior to the existing shares) 2.Buying troubled assets alone is not likely to solve the capital shortage. Assets purchase program must be combined with recapitalization program – could be privately funded. 3.Programs must be big enough. 4. Programs must be preceded by rigorous inspection (to determine the size of the problem) 5.Troubled assets purchased by AMCs should be put back into the private sector or restructured swiftly. 6.Nationalization can be useful to wind down systemically important banks. 7.Targeting total lending or lending to specific sectors can be counter- productive. 8.Recapitalization ultimately driven by macroeconomic recovery 35

36 Conclusions Asking the banks to earn their way out of the capital shortage is a gamble Politics can be very difficult if more money is needed – Is GM the largest zombie ever? Too early to declare mission accomplished 36

37 Extra slides 37

38 38 JPMWachoviaBank of AmericaState StreetWells Fargo $ BillionsBank% assetsBank% assetsBank% assetsBank% assetsBank% assets Level 2 Loans and leases1.50.1%0.00.0%4.20.2%0.00.0%12.12.1% Trading assets1336.053.6%98.614.5%668.438.7%20.06.8%10.01.8% Other financial assets22.80.9%0.00.0%2.60.2%0.10.0%0.00.0% Level 3 Loans and leases5.90.2%0.00.0%7.60.4%0.00.0%5.10.9% Trading assets65.42.6%12.31.8%11.00.6%1.10.4%0.40.1% Other financial assets0.00.0%0.00.0%0.00.0%0.00.0%0.00.0% Total Assets2490.8100.0%680.8100.0%1728.6100.0%296.3100.0%569.3100.0% CitigroupMorgan StanleyGoldman SachsBank of NY $ BillionsBank% assetsBank% assetsBank% assetsBank% assets Level 2 Loans and leases9.90.6%7.219.0%0.52.1%0.00.0% Trading assets676.337.9%5.614.8%7.634.9%8.93.7% Other financial assets0.10.0%0.00.0%8.238.1%0.00.0% Level 3 Loans and leases0.10.0%2.56.6%1.04.8%0.00.0% Trading assets58.03.3%0.00.0%0.00.0%0.10.1% Other financial assets0.00.0%0.00.0%0.00.0%0.00.0% Total Assets1783.3100.0%37.6100.0%21.6100.0%238.8100.0% Source: Call Reports as of Sep 30 2008 Hard to value assets in the trading book of JPM, Bank of America and Citi exceeds $2.5 trillion

39 Data as of September 2008 (except Morgan Stanley and Goldman Sachs as August)Exposure to Name Total Assets Total CommitmentsLendingReal Estate Credit Card Other Consumer Equity/ Assets Max Dividend Payout JPMORGAN CHASE2,251.51,223.657.8%19.2%25.3%1.8%6.5%5.67 BANK OF AMERICA1,836.51,423.173.3%29.4%28.8%3.0%8.8%5.84 MERRILL LYNCH875.8123.720.0%8.8%0.0%0.5%4.4%2.22 STATE STREET CORP286.750.920.3%7.4%1.1%2.7%4.6%0.41 CITIGROUP2,050.11,560.065.0%12.4%32.9%4.3%6.1%3.49 BANK OF NY MELLON267.645.533.4%9.9%0.2%0.4%10.3%1.10 WELLS FARGO (incl. Wachovia)1,382.9476.975.5%45.7%6.2%5.2%7.0%4.52 MORGAN STANLEY987.4162.015.8%21.9%0.0% 3.6%1.20 GOLDMAN SACHS1,081.878.59.3%8.3%0.0% 4.2%0.55 TOTAL11,020.35,144.354.5%21.1%19.3%2.6%6.3%25.0 Note: Combined Merrill Lynch and Bank of America2,712.21,546.860.8%24.5%22.0%2.4%7.4%8.1 Selected Data on Major Institutions Participating in the TARP ($ billion) 39

40 40

41 41 Zombies defined as firms getting subsidized credit The sample is listed firms in manufacturing, construction, real estate, retail and wholesale (other than the nine largest general trading companies), and services

42 42 Zombies Hurt Non-Zombies Employment growth or Investment

43 Zombies Hurt Non-Zombies 43 Dependent VariableI/K ΔLog E Sample1993- 2002 1993- 2002 Constant0.239 (0.008) 0.014 (0.002) Non-Zombie Dummy0.026 (0.006) 0.0011 (0.0018) Industry Zombie %-0.137 (0.038) -0.045 (0.012) Non-Zombie * Industry Zombie%-0.089 (0.033) -0.023 (0.010) 0.0540.090

44 44 Cross-industry incidence of zombies

45 45

46 Selected Data on Major Japanese Banks (¥ million, 1998) 46 Exposures to Bank total assets total loansLoans Real Estate Construc tion FinancialSMC capital/ asstot Dividends IBJ 45,140,863 19,821,42743.91%5.44%1.12%8.09%19.10%2.36%21586 LTCB26,190,00514,639,64955.90%10.32%1.52%14.14%25.86%3.01%14356 NCB 12,659,064 7,678,56160.66%19.47%2.25%15.89%37.20%3.69%0 Daiichi Kangyo Bank 53,798,398 26,759,29849.74%6.07%2.68%4.10%34.57%2.68%26527 SAKURA BANK 51,650,386 29,303,13256.73%8.97%3.08%5.28%40.04%2.51%32337 Fuji Bank 51,088,094 23,442,09245.89%4.45%2.14%4.15%34.76%2.23%25154 ASAHI BANK 29,267,330 17,772,99360.73%7.17%3.74%2.98%46.48%2.58%14437 Sanwa Bank 52,708,359 24,247,23746.00%6.81%1.98%4.04%35.73%2.73%24742 SUMITOMO Bank 58,076,795 28,530,37349.13%6.89%2.73%3.78%36.46%1.96%26698 Daiwa Bank 16,740,731 10,730,13964.10%13.40%3.52%6.72%45.28%2.84%10910 TOKAI BANK 31,943,567 17,126,82553.62%7.55%3.06%4.96%36.01%2.44%20684 ASHIKAGA BANK 5,933,298 4,543,20576.57%6.13%7.26%3.61%58.31%2.38%3110 BANK OF YOKOHAMA 11,258,367 7,884,62370.03%9.37%4.70%4.61%51.70%2.45%5688 HOKURIKU BANK 6,619,220 4,838,59773.10%6.72%8.00%2.50%52.91%2.79%1372 MITSUI TRUST 12,056,928 8,960,10874.32%13.16%2.45%11.29%35.43%3.27%5992 MITSUBISHI TRUST 18,158,026 11,279,84362.12%10.65%2.10%11.35%26.23%2.70%10418 Toyo TRUST 8,154,838 7,117,60587.28%17.96%2.48%18.92%42.92%3.48%5506 CHUO TRUST 3,704,007 3,591,35796.96%18.32%1.87%20.18%54.30%4.89%1383 SUMITOMO TRUST 15,643,662 11,186,51971.51%12.92%2.38%13.98%31.55%2.44%9952 Total510,791,938279,453,58354.71%8.16%2.63%6.48%35.65%2.57% 260,852

47 47


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