|
Article Excerpt
We're now most worried about credit associations and cooperatives. Government financial inspectors will audit them between July and next March. If you think audits on your institutions are too strict, please inform us about it. Please tell Mr. Hasumi about it. If you give related documents to him, and he will in turn pass it over to me, I'll give the utmost consideration.--A speech by Financial Reconstruction Minister Michio Ochi at a gathering of regional bankers and credit associations and cooperatives officials in Tochigi prefecture hosted by Susumu Hasumi, a senior Lower House member of the ruling Liberal Democratic Party on February 19, 2000.
ECONOMISTS HAVE LONG claimed that a great deal of government regulation stems from political pressures applied to legislatures by private interest groups (Stigler 1971, Peltzman 1976, Olson 1982, Becker 1983). Bank regulation is no exception to this principle. Many studies have found that the historical restrictions on branching and universal banking and the adoption of the deposit insurance system in the United States resulted from the dominance of politically influential small unit banks (White 1981, 1982, Economides, Hubbard, and Palia 1996, Kroszner and Strahan 1999, Ramirez and De Long 2001). Similarly, a careful examination of the design and adoption of deposit insurance in different countries reveals strong presence of political forces: generous deposit insurance schemes tended to be adopted in countries where the banking sector was dominated by weak banks that would benefit from weak market discipline and regulatory forbearance (Laeven 2004, Demirguc-Kunt, Kane, and Laeven 2008).
Furthermore, the desired regulatory outcome is not guaranteed even if a country somehow overcomes political obstacles and adopts the so-called "best practice" that is often promoted by multinational organizations (e.g., the Basel Committee on Banking Supervision). In a recent book, Rethinking Bank Regulation: Till Angels Govern, Barth, Caprio, and Levine (2006) show that the traditional regulatory approach of raising capital adequacy requirements and empowering bank supervisory agencies to enforce risk-reducing regulations did not always lead to an efficient and stable banking sector in many countries. Rather, this government-led bank regulation and supervision is associated with small and weak banking sectors and an increase in corrupt lending practice, suggesting that regulatory agencies themselves might be "politically captured" in many countries. In other words, bank regulatory agencies might be pursuing the narrow private interests of politically connected bankers, politicians, and their supporters, rather than public interests. Because of the politicization of bank regulation and supervision, some economists also make a normative argument that the promotion of market discipline through uninsured debt requirement and systematic public disclosure of information is more likely to foster a robust banking sector than government-led bank regulation and supervision alone (Calomiris 2004, Herring 2004, Barth, Caprio, and Levine 2006).
For this paper, I combine balance sheet and failure data from Japan's regional banks and credit associations and cooperatives from 1999 to 2002 with matched data on political and economic characteristics of prefectures where these banks were located. I use these data to investigate the potential politicization of bank supervision in Japan and to illuminate the mechanism through which political incentives influenced the behavior and performance of Japan's bank regulatory agency. More specifically, I perform survival analysis to examine the statistical pattern of bank failures, which in this paper refers exclusively to government takeover of ownership and management of insolvent banks, and to investigate whether there was any tendency to delay bank failures in prefectures that supported the ruling political party and/or the senior influential politicians of the ruling party.
Japan's experience with the resolution of bank insolvency during this period offers an informative setting in which the performance of its regulatory agency can be analyzed. Being concerned about systemic banking crisis, the Japanese government provided a blanket guarantee of bank deposits, which substantially minimized the role of market discipline in weeding out insolvent banks from the financial system (Imai 2006). This blanket guarantee, however, was scheduled to expire on March 31, 2002, necessitating bank regulators to resolve weak banks before this date in order to prevent bank runs. (1) Consequently, during the period of this paper's analysis (1999-2002), bank regulators were given clear mandate and authority to clean up banking sector.
Hence, if public interest view of bank regulation and supervision is correct, then the data should show that the regulatory agency was effective in monitoring banks, and that its behavior should mimic that of well-informed market participants. That is, bank failures (i.e., government takeovers of ownership and management) should have been determined solely by bank health and local economic conditions that would affect bank health and depositors' confidence. If, on the other hand, political capture view is correct, then bank regulators might have taken the private interests of bankers and the ruling political party and influential politicians into account, which in turn might have distorted bank regulators' action. Specifically, bank regulators might have been reluctant to take over promptly insolvent banks that were located in areas that supported the ruling political party and/or its senior members that can effectively influence the actions of bank regulators.
The main result of this paper shows that banks that were located in the prefectures that supported the senior member of the ruling Liberal Democratic Party (LDP) tended to survive longer than those located in the prefectures that supported junior politicians. This result is broadly consistent with political capture view of bank supervision articulated by Barth, Caprio, and Levine (2006), casting some doubt on the practical merit of relying heavily on regulatory discipline in a politicized environment.
Although the aforementioned statistical result suggests the presence of "political effects," it is also possible that banks in LDP strongholds might have been relatively healthy. If that is the case, it would not be surprising to see that these banks survived longer than their counterparts in other prefectures. Nonetheless, the correlation between bank failure hazard and the seniority of the LDP politicians is found to be quite robust to the inclusion of bank characteristics such as capital-to-asset ratio, return on assets, and the type and size of banks in the survival analysis. Another potential concern might be that the extent of support for the LDP politicians might plausibly be determined endogenously by the economic conditions of prefectures, which in turn have some effects on the health of the financial sector and bank failure hazard rates. The political effects on bank supervision, however, remain strong and statistically significant even when I control for observable prefecture-level characteristics such local income growth, local labor market conditions, and local business bankruptcy rates.
Two papers are directly relevant to this paper. Bongini, Claessens, and Fend (2001) estimate the effects of political connections on regulators' closure of banks in Indonesia, Malaysia, Korea, Thailand, and the Philippines. Somewhat surprisingly, given the allegations of "crony capitalism" in these countries, they find that political connections played virtually no role in the bank closure decision of governments while bank risk-profile has strong explanatory power. Looking specifically at the timing of bank failures in emerging market economies, Brown and Dinc (2005) find that bank failures were clustered after elections, suggesting that bank regulators had a tendency to delay the politically costly resolution of banking problems during elections. This paper differs from these previous papers in that it exploits variation in political characteristics across Japan's prefectures to shed some light on whether the ruling political party or influential politicians can potentially distort the bank supervisory agency's decisions in their favor. This type of microeconomic study is helpful in understanding how bank supervision can be politicized and more importantly what kind of institutions is necessary to provide adequate incentives and constraints to bank regulators and to achieve better bank supervision. This is also the first study to examine empirically the politics of bank insolvency resolution in the context of Japan's severe and painfully long banking problem.
The rest of this paper is organized as follows. Section 1 briefly describes the background of Japan's banking problem, bank resolution policy, and politics. Section 2 quantitatively examines whether political influence distorted bank failure decisions. Section 3 presents concluding remarks.
1. BACKGROUND
1.1 Banking Problem
Japan's decade-long banking problem started with the collapse of the asset market in 1990-93, which developed into one of the severest banking problems of the 1990s. According to Caprio and Klingebiel (2003), the fiscal cost of resolution of the banking problem in Japan is estimated as much as 24% of GDP, making it among the costliest banking crisis ever. Additionally, if one takes into account the economic costs of the well-documented credit crunch and "ever-greening" of bad loans by insolvent banks (Motonishi and Yoshikawa 1999, Sekine, Kobayashi, and Saita 2003, Woo 2003, Peek and Rosengren 2005, Caballero, Hoshi, and Kashyap 2006, Watanabe 2006, Okada and Horioka 2007), the total cost of the 1990s banking crisis to the Japanese economy might even be higher than the Caprio-Klingebiel estimate. Additionally, Japan's banking problem distinguishes itself from other episodes as it lasted more than a decade (Hutchison and McDill 1999, Fukao 2003).
The causes of Japan's banking problem are well documented in the literature. The starting point is a poorly designed deregulation of the financial market during the 1970-80s that expanded the access of high-quality bank borrowers to bond and stock markets while not allowing savers (i.e., households), the same access to these markets. This lopsided deregulation led to disequilibrium in which banks were left with excess funds, which, in turn, were allocated to unfamiliar and risky borrowers such as small businesses and the real estate sector (Hoshi and Kashyap 2000). With profit margins dangerously low and balance sheets vulnerable to macroeconomic shocks, the collapse of Japan's asset market in 1990 and the ensuing recession led to a large-scale banking problem.
1.2 Bank Insolvency Resolution
To the extent that Japan's banking problem resulted from a structural imbalance between the demand for bank loans and supply of deposits, the shrinkage of bank deposits and assets and/or the closure of unprofitable banks were imperative (Hoshi] and Kashyap 2000). Nevertheless, the Japanese government and the ruling LDP were initially quite reluctant to close down promptly insolvent banks and to use taxpayers' money to recapitalize banks that were undercapitalized yet still viable (Corbett 1999, Milhaupt 1999, Amyx 2004). Instead of decisively dealing with problem banks, the government used the reserves of the Deposit Insurance Corporation (DIC) to encourage large banks to acquire insolvent banks via so-called convoy scheme (Hoshi] 2002). The government also allowed a private solution in which banks and affiliated insurance companies simply purchased equity and subordinated debts from one another to artificially raise their solvency ratio (Fukao 2003). Moreover, the government decided in 1996 to remove the cap on the amount that the DIC was allowed to pay to assist mergers and the acquisition of problem banks, thereby weakening depositor monitoring (Cargill, Hutchison, and Ito 1996, Imai 2006).
A turning point in bank resolution policy came in 1997 and 1998, when market participants lost confidence in the government's accommodating approach to resolving problem banks, and as a result, began punishing Japan's weak banks (Peek and Rosengren 2001, Spiegel and Yamori 2004). Moreover, as voters became increasingly discontent with the ruling LDP's handling of...
|
