Gary R. Saxonhouse and Robert M. Stern
banking sector problem. Nevertheless, the situation was exacerbated, Kawai 289
argues, by the absence of a tradition of assessing and pricing the risks in lending to 290
particular borrowers. This was an important factor in the over-extension of col- 291
lateral-based but risky loans. And the entire problem was made even worse by the 292
banks operating within a very weak prudential and supervisory framework. 293
Kawai finds that the absence of a comprehensive strategy addressing the 294
banking sector problem when it first emerged was clearly a mistake that allowed a 295
systemic banking crisis to emerge in 1997-1998 to be followed by a large output 296
loss during 1998-2002. Japan’s financial authorities underestimated the nature and 297
seriousness of the problem, had unwarranted expectations of renewed growth that 298
they hoped would restore asset values and bank balance sheets, and continued 299
fiscal expansion to support aggregate demand that allowed insolvent banks to 300
survive thereby delaying resolution of the problem. 301
The 1997-1998 crisis did prompt the government to take more aggressive and 302
decisive measures. Kawai notes that there has been some progress on banking 303
sector restructuring through the closing or temporary nationalization of non-viable 304
banks, tighter loan classification and loan provisioning, and the acceleration of 305
NPL disposal. The worst may be over, but there remain significant risks con- 306
centrated in regional and smaller banks that are vulnerable to weak local condi- 307
tions, persistent deflation, and increases in the long-term interest rate. 308
4.2 What role for Japan’s Banks 309
The regulatory framework that was in place for much of the second half of the last 310
century in Japan put the banking system at the center of resource allocation. Kyoji 311
Fukao, Kiyohiko G. Nishimura, Qing-Yuan Sui and Masayo Tomiyama in their 312
paper “Japanese Bank Monitoring Activities and the Performance of Borrower 313
Firms 1981-1996” attempt to assess empirically the contributions made by 314
Japanese banks. They find that after 1981, following widespread organizational 315
changes, both the resources devoted to and the quality of what bank monitoring 316
was done declined. While there remained a positive association between bank 317
monitoring and firm profitability, this was mostly due to the banks choosing the 318
most profitable loan applicants rather than because banks in any significant way 319
provided advice that enhanced the profitability of their borrowers. It is a measure of 320
the current low esteem in which banks are held that even the result that they are 321
able to successfully screen loan applicants seems surprising and is at variance with 322
the conclusions drawn by Kawai. Even so, if Japanese banks are to play an 323
important role in Japan’s economy in the future they will in all likelihood need to 324
have a monitoring function that does provide value-added to their borrowers. 325
This last point is underlined by the results in the paper by Alan Ahearne and 326
Naoki Shinada, “Zombie Firms and Economic Stagnation in Japan”. Zombie firms 327
are debt-ridden companies that, despite their dismal performance, continue to re- 328
ceive financial support from borrowers who at some earlier time viewed them as 329
safe, profitable borrowers. Measured productivity growth of these firms has tended 330
to be well below the average for the rest of the economy, or even negative, putting 331
a significant drag on the productivity performance of the Japanese economy as 332
a whole. Worse, Ahearne and Shinada find that in the construction, wholesale, 333
and retailing sectors where there are large concentrations of zombie firms the 334