The U.S. government has taken a schizophrenic policy approach to the ongoing credit crisis. In the Treasury’s deliberations with Congress, it stressed idea of purchasing troubled assets to stabilize the financial system. Thus, the Troubled Assets Relief Program (TARP) became the central part of the Emergency Economic Stabilization Act (EESA). But within a week of passing the legislation, attention shifted to buying equity in financial institutions.
Subsequently the Capital Purchase Program (CPP) within the TARP is using $250 billion of public funds to acquire stakes in banks in the form of preferred shares and warrants, with $145 billion already allocated to nine major banks. It appears possible that asset purchases may even be abandoned altogether.
The focus on the capital shortage is good news since economists widely agree that the lack of capital is the fundamental problem plaguing the banks (Baldwin and Eichengren (2008)). But, the try everything approach without careful regard for implications also bears an eerie resemblance to Japan’s decade-long response to its financial crisis. The big difference thus far is that the U.S. is moving much more quickly than Japan did. Hence it is instructive to look back at Japan’s experience to see what did and did not work.
We begin with a review of the macroeconomic environment that prevailed in Japan and the U.S. during these episodes. While it is widely known that the banking problems in both countries began after a sharp increase in land prices, the events in Japan from late 1997 to early 1999 closely track developments in the U.S. in 2008. One important similarity is the bank credit crunch that prevailed in both instances. More importantly, the Japanese banks emerged from the acute phase of its crisis with seriously undercapitalized banks.
We next describe the string of Japanese asset purchase plans and capital injection programs that were pursued to combat the banking problems. There were four main problems with these strategies. First, the asset purchase plans were too narrow. The scope of assets to be purchased and the set of financial institutions included were limited, thus precluding a comprehensive plan. Second, the loan purchases that did take place, especially in the 1990s, involved little restructuring of the borrowers.
This resulted in many of the companies operating with few changes while typically receiving more loans that subsequently went bad. Third, the capital purchase plans ran into trouble in getting the banks to accept funding. Fourth and most importantly, the overall amount of government money committed was too small to recapitalize the banks. Hence, the banks only really returned to being adequately capitalized in 2006 and 2007, when macroeconomic conditions improved and after supervision policy had changed.
We close by drawing on the Japanese experience to evaluate the troubled asset purchase program and the CPP. In broad terms, the two programs mimic many elements of the Japanese plans. We present data comparing the largest U.S. banks, particularly in terms of the risks that they face from continued deterioration in the economy. Based on publicly available data it is hard to make confident assessments about the solvency of the banks.
The lesson from Japan is that the details of the potential recapitalization program will be critical in determining whether any injections will increase the banks’ capital levels and hence their lending capacity. There are too many open issues about how the TARP will proceed to tell whether it can avoid the mistakes made in Japan.
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PDF Ebook Will the U.S. Bank Recapitalization Succeed? Lessons from Japan
