Japan's Financial Functions Stabilization Act

In December 1997, the ruling Liberal Democratic Party announced the first Japanese recapitalization for banks in the post-war era (Japan Times 1997b). In a separate bill, the Diet amend the Deposit Insurance Act (Japan Times 1998h; Japan Times 1998i). Through the new bills, a total of ¥30 trillion of public funds was made available: ¥17 trillion for the DICJ to cover the losses of failed financial institutions (up from an original ¥300 billion); ¥13 trillion for capital injections into banks (Nakaso 2001).

Prime Minister Hashimoto also announced a ¥2 trillion income tax reduction, aimed at jump-starting the economy, on December 17, 1997. The tax cut was funded through government-issued bonds and was submitted to the Diet as a supplement to the fiscal year 1997 budget (Japan Times 1998a). On February 4, 1998, the Diet passed a supplementary budget that provided financing for the ¥2 trillion personal income tax cut (Japan Times 1998g).

The legislation was the first in a series of capital injections from 1998–2008, with a second capital injection in March 1998 and a third injection legislation in June 2004 (Hoshi and Kashyap 2010).

In December 1997, the ruling Liberal Democratic Party announced the first Japanese recapitalization for banks in the post-war era (Japan Times 1997b). The day after the announcement of the recapitalization, the Nikkei average jumped 2.5% in a show of investor relief. However, some ratings agencies continued downgrading major Japanese banks, with Standard & Poor’s downgrades occurring on December 25, one day after the announcement by the LDP (Japan Times 1997c). Moody’s kept ratings low, even after banks began applications for recapitalization in March 1998 (Japan Times 1998k).

The Financial Functions Stabilization Act established the intended recapitalization. The FFSA was a temporary measure intended to utilize public funding for capital injections to increase stability in the Japanese financial system (Nakaso 2001). The act allocated ¥13 trillion ($103 billion) for the recapitalization of undercapitalized banks (Japan Times 1998i).

After finalizing the banking bills, Prime Minister Ryutaro Hashimoto’s Cabinet submitted the finalized version of two bills—one for increased depositor protection and one for recapitalization—to the Diet on January 19, 1998 (Japan Times 1998e). To encourage the passage of the bills, Prime Minister Hashimoto unconventionally visited the Diet to give a series of speeches on the necessity of the financial system stability measures (Japan Times 1998a; Japan Times 1998b; Japan Times 1998d; Japan Times 1998f).

Additionally, prior to the passage of the bill, the Japanese government worked to encourage banks to participate in the program, praising banks choosing to participate in the program in the hope that the vocal participation of stronger banks would encourage weaker rivals to participate as well (Japan Times 1998c).

After passing the Lower House on February 7, the bills passed the Upper House on February 16 and were formally enacted into law (Japan Times 1998h; Japan Times 1998i).

To apply for funding, banks would submit plans to the Financial Supervisory Agency (FSA), who would then apply to the FCMC on their behalf (Financial Functions Stabilization Act 1998).

The FCMC served as an in-house committee of the DICJ (Japan Times 1998j). As the Prime Minister’s office hoped to have injections done before April 1, 1998, the beginning of the new fiscal year, the FCMC was on a strict timeline (Japan Times 1998h). The FCMC consisted of seven members, with three members from the private sector, the Minister of Finance, the Commissioner of the Financial Supervisory Agency, the President of the Bank of Japan, and the President of the DICJ (Financial Functions Stabilization Act 1998). Yoko Sazanami, an academic at Keio University, chaired the Committee, though domestic finance was outside of Sazanami’s research focus as an international economist (Madden and Dimand 2018). The Cabinet-appointed members of the committee were appointed with consent from both houses of the Diet (Financial Functions Stabilization Act 1998). The Cabinet was responsible for terminating the operation of the FCMC (Financial Functions Stabilization Act 1998).

The FCMC met six times between February 16 and March 31 (Cargill, Hutchison, and Ito 2001). The committee decided votes through simple majority, with the Chairperson acting as the tie-breaking vote. After the decision passed through the committee, it was sent to the Cabinet for full approval. In the case of credit cooperatives, also eligible for capital injection under the Financial Functions Stabilization Act, the law required the prefectural governor also be consulted. In the case of the Federation of Agricultural and Fisheries Cooperative Associations, the Minister of Agriculture, Forestry, and Fisheries was consulted (Financial Functions Stabilization Act 1998).

The Resolution and Collection Bank (RCB), the asset management corporation tasked with holding the preferred shares and subordinated loans and debts of the banks applying for capital injection, was formed from the reorganization of the Tokyo Kyoudou Bank in June 1996. At its formation, the RCB had a broader role as an assuming bank for failed credit cooperatives, when there were no assuming banks in the private sector. In addition, the RCB could purchase non-performing loans from failed financial institutions, increasing the incentives for solvent institutions to assume the failed institution (Nakaso 2001). After restructuring, the RCB became a 75% subsidiary of the DICJ, receiving ¥120 billion in capital from the DICJ, ¥20 billion from the Tokyo Kyoudou Bank, and ¥20 billion from the Bank of Japan (DICJ 2002; Nakaso 2001).

The DICJ acts independently of the Bank of Japan or the Treasury, though in close cooperation. The issuance of government-backed DICJ bonds, as well as annual budgetary appropriations, funds the DICJ’s financial assistance. In rare instances, the DICJ may borrow money directly from the Bank of Japan (FSB 2016). Funding for the FFSA came from ¥3 trillion of special government bonds that the DICJ could cash on request, and ¥10 trillion in government-guaranteed credit lines (Nakaso 2001).

Through the RCB, the DICJ purchased the preferred shares and subordinated debts of banks out of the crisis management account (Hoshi and Kashyap 2010; DICJ n.d.).

Any domestic or foreign bank was eligible for a capital injection, though no foreign banks participated in the injection (Financial Functions Stabilization Act 1998; DICJ n.d.). Credit cooperatives as well as Shinkin banks, a type of cooperative regional credit union, were also eligible. In addition to the financial institutions eligible for capital injection, a set of non-bank financial institutions, all cooperatives, were also eligible: Norinchukin Bank, Agricultural Cooperative Association, and the Federation of Fisheries Cooperative Associations (DICJ 1998a). The law did not require the participation of any banks, though there was some debate regarding forced injections during the summer of 1998 during discussions to amend the capital injection framework. However, this idea was ultimately abandoned (Nakaso 2001).

There were some standards for screening in determining whether the banks needed capitalization: banks could not be losing money for three years prior to application, the banks applying were important to the financial and credit system, and banks were unlikely to fail. Details are shown in Figure 6 below.

The FCMC was responsible for determining underwriting terms for preferred shares and subordinated debt issued through the recapitalization scheme (Financial Functions Stabilization Act 1998; Nakaso 2001). The FCMC determined the terms of the capital injections on a case-by-case basis. Banks received differing yield rates on subordinated bonds ranging from LIBOR + 0.55 percent to as high as LIBOR + 2.95 percent. After five years, the rates on subordinated bonds were raised by 1.50 percent. Banks selling preferred shares had differing conversion dates (DICJ 2020). The preferred shares purchased were converted to common shares after a grace period; Kanaya notes when examining a similar policy utilized in the March 1999 capital injection that the conversion of common shares gave the government the opportunity to act as an activist shareholder, forcing restructuring if dissatisfied with the bank’s progress (DICJ 2020; Kanaya and Woo 2000). While banks had the ability to acquire shares with approval by the DICJ, in practice, the small windows before conversion (at most seven months after the injection) led to all preferred shares in the injection being converted to common shares (DICJ 2020; Financial Functions Stabilization Act 1998).

Unlike the later recapitalization legislation, the Prompt Recapitalization Act, the law did not give the FCMC supervisory power as it was housed in the DICJ, a non-supervisory institution (Nakaso 2001). The FFSA instead required banks to self-report balance sheet information checked by independent auditors to the Financial Supervisory Agency. Banks applying for capital injections under the FFSA also were required to submit self-assessments on the quality of assets on their balance sheets to the Financial Supervisory Agency. Certified public accountants audited these self-assessments as well (FSA 1998).

These assets were partitioned into four categories:

Category I assets were assets not considered needing risk management in any form and were collectable;

Category II assets were credit exposures for which banks judged that adequate risk management on an exposure-by-exposure basis would be needed;

Category III assets were those about which banks had serious concerns in terms of their collection and were likely to incur losses, but banks were unable to determine the timing or size of the losses;

Finally, category IV losses were exposures that banks were unable to collect or valueless (FSA 1998).

Under this assessment structure, banks estimated the size of their categories II, III, and IV assets to be ¥65.3 trillion, ¥8.7 trillion, and ¥2.7 trillion respectively as of January 1998 (FSA 1998). The self-assessment results under the FFSA are shown in Figure 7 below.

Figure 7: Results of self-assessment of asset quality for Japanese Banks applying for recapitalization under the Financial Function Stabilization Act (in billions of yen)
Source: Financial Supervisory Agency 1998.

Institutions submitted these audits to the Financial Supervisory Agency, which was responsible for submitting the application to the FCMC (FSA 1998; Financial Functions Stabilization Act 1998).

Unlike its successor, the Prompt Recapitalization Act, the FFSA did not place any moratorium on management compensation or dividends under the law. However, there was a requirement to pay some portion of the dividends to the DICJ, based on cabinet ordinance.

Average pay for executives of these banks varied by each bank. Some banks, such as the Tokai Bank, did not show a reduction in average pay but posited that the costs would decrease as the makeup of executive boards changed. Other banks such as the Bank of Tokyo-Mitsubishi showed cost cutting through maintaining average pay and decreasing the number of executives. Most of the 21 banks planned to pay their executives ¥20 million or more a year, and stated so as part of their public restructuring plans (Japan Times 1998n).

All banks receiving a capital injection in the form of subordinated loans or debt had step-up clauses on the debt or loans injected. The step-up clauses, increasing the yield of the bonds and debts, would come into effect six years after the injection. Each yield rate and change in rates varied by bank. In addition, a majority of the subordinated loans and debts purchased were perpetual, never expiring (DICJ 2020).

Banks receiving preferred shares faced mandatory conversion dates on the issued preferred shares. These mandatory conversion dates were set to take place within eight months of the capital injection (DICJ 2020).

All banks receiving capital injections repurchased their shares, loans, and debt, within ten years, with the exception of Nippon Credit Bank and the Long-Term Credit Bank of Japan, which repurchased their debts in June 2015 and November 2017, respectively (DICJ 2020). In the summer of 1998, the Long-Term Credit Bank of Japan failed, leading to the Financial Reconstruction Law, under which the Japanese government nationalized the bank. The Nippon Credit Bank followed in December 1998, and was nationalized under the same legislation (Nakaso 2001).