Japan's city banks and other banks
Japan's city banks hold the most assets of any financial group. The 11 city banks have total assets of around ¥400 trillion. The six largest city banks are Dai-Ichi Kangyo, Sumimoto, Sakura, Fuji, Sanwa and Mitsubishi. These are the six largest banks in the world, each with average asset size of over $400 billion. They are all more than twice the size of Citicorp, America's biggest bank.
Unlike the US Japan doesn't have any hang-ups about nationwide branch banking, and most city banks have around 200 branches. For this and other reasons the city banks are much larger than America's banks.
Because of their size, city banks are largely wholesale money institutions. Although they accept individual deposits and provide some consumer loans, city banks historically have lent to larger industrial firms.
City banks experienced heavy loan demand during the high growth period of the 1960s and 1970s. During this time there was no corporate bond market in Japan, so firms relied heavily on bank loans. Because loan demand often exceeded their available funds, Japanese city banks borrowed funds from regional banks in the interbank loan market.
To ensure access to bank loans, industrial firms bought equity stakes in banks. In turn, city banks bought shares of their industrial clients. This cross-shareholding formed the nexus of the keiretsu or network of corporations.
Keiretsu arose out of the zaibatsu that existed before World War II. The zaibatsu were large holding companies with names like Sumitomo, Mitsui and Mitsubishi. Believing that the zaibatsu were one of the causes of a militaristic Japan, the American forces outlawed holding companies with the 1947 Anti Monopoly Law.
America also tried to reduce the power of the city banks by separating banks and securities companies. This had a major impact on Japanese finance because it increased the importance of the securities firms. Before the war the securities firms were fringe players overseeing a highly speculative stock market. Because industry now had to use the securities firms to tap the equity markets, the securities firms became stronger.
But they never really became strong enough. Although the old zaibatsu were dismantled and their assets sold to individuals after the war, individuals resold their shares back to keiretsu firms.
City banks played a key role in this reformation. Banks could hold only five percent of the stock of a particular firm, but this was good enough. Japanese companies have always been highly levered, and bank lending rather than equity provided the financial muscle.
Although city banks could only extend short-term loans, they were really long-term loans because it was understood that the loan would be rolled over upon expiration.
This arrangement worked well, but by the 1980s the link between banks and their corporate clients began to crumble. After the government eased access in 1984 to the Eurobond market, Japanese corporations began to obtain funds through Eurobonds. This, coupled with large equity offerings in the Japanese bull market of the late 1980s, meant bank loans were no longer the preferred source of capital.
A few numbers illustrate the shift from bank loans to securities. In 1975 corporations obtained 15 percent of their funds from bonds and equity and 85 percent from bank loans. By 1989 the percentage of securities had doubled, and bank loans had dropped to 65 percent of corporate liabilities.
More importantly, most new funds came from securities. In 1989 seventy percent of all new corporate funds came from securities and not bank loans.
In spite of losing their corporate customers, banks were still growing quickly in the 1980s. In yen terms assets of banks grew annually at 14 percent. For comparison, dollar-denominated assets of American banks grew only 6 percent annually during the 1980s.
So with increasing assets, but fewer industrial clients, to whom did the banks lend?
From 1975 until 1984 real estate loans in Japan averaged about ¥2 trillion per year. From 1985 to 1989, real estate loans spiked up to ¥8 trillion per year. Note the shift occurred after Japanese companies began to issue large sums of Eurobonds.
This caused the so-called bubble economy. Banks lent huge sums for acquisition and development of property. This then pushed up the value of all surrounding property. Property owners then would borrow against the value of their increased property and invest in the stock market.
The effect of this spiral of asset prices was clear. The Nikkei stock index rose 100 percent from 1987 to 1989. Likewise, land prices in Tokyo and Osaka doubled in the same period.
The bubble burst in 1990 when the new governor of the Bank of Japan rapidly hiked the discount rate from 2.5 percent to 6 percent. Stocks dutifully fell 60 percent in two years.
The crash however left many problems for banks. The first was bad loans which now total about 4 percent of all bank loans. For some reason, perhaps because of the almost mystical value of land in crowded Japan, banks extended property loans based solely on the value of the collateral.
The bankers didn't really look at the potential earnings that the property could generate. They just looked at today's bloated price, and approved a loan for 70 percent of the collateral's value.
Property lending was risky, but at the time Japanese banks were desperate for new loan business. Also for some reason, Japanese bankers were more concerned with asset growth than with earnings growth for their banks.
This can be seen in two areas. First, in the late 1980s - during an economic boom - Japanese banks had a meager return on assets of 0.4 percent per year. In contrast American banks have an average return on assets of over twice that.
Second, low growth in retained earnings and large asset growth lead Japanese banks to become undercapitalized. Japanese banks were increasing their assets by accepting more deposits and extending more loans, but these assets were cushioned with a smaller and smaller slice of shareholder equity.
Japanese banks have historically been thinly capitalized, but their low capitalization became a problem when the Bank for International Settlements - the central bank of the world's central banks - devised minimum capitalization requirements in the mid 1980s.
The BIS wanted major international banks to have at least 8 percent of their assets in equity or reserves. This would serve as a minimum cushion for bank loses.
American banks have had capitalization rates of around 6 percent, so increasing to the 8 percent figure was not too difficult. Japanese banks, however, with average capitalization ratios of 4 percent, faced a more daunting task.
The Japanese argued that they should be able to include hidden assets in their capitalization figures. Bankers reasoned that they had trillions of yen in unrealized gains in stocks that they had acquired many years ago, and this ought to be worth something.
The BIS agreed, and Japanese banks can count 45 percent of the value of the appreciation of their stock holdings when determining their capitalization ratio.
Although the Japanese were glad that they could count some of their stock holdings toward capitalization requirements, there is a drawback to this.
Because the capitalization of Japanese banks now is tied to the volatile stock market, so is the banks' ability to lend funds. In a worst-case scenario, Japanese banks can not extend new loans when the economy and the stock market are in the tank.
This of course is what happened in the early 1990s. As Japanese stocks fell, the government stepped in and spent ¥4 trillion in Trust Fund Bureau money to prop up the market. This so-called "price keeping operation" enabled Japanese banks to meet BIS capitalization requirements by the April 1993 deadline.
Because Japanese banks have subsequently improved their capitalization ratios, this government rescue is unlikely to be repeated. However this underscores the importance of the city banks to the Japanese economy.
In Japan bank loans equal 90 percent of nominal GDP. In the more sophisticated financial markets of America, bank loans total only one-third of GDP. Japanese banks have become too large to be allowed to die or even catch a severe cold.