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Foreign direct investment and regulatory remedies for banking crises: Lessons from Japan

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Abstract

Can regulatory interventions alleviate financial crises? If so, which ones work? We draw inferences from the Japanese banking crisis of the 1990s using a hand-gathered database of bank loans gathered from original sources. Our results indicate that whereas risk-based capital infusions in Japan (similar to those following the 2009 Supervisory Capital Assessment Program (stress tests) in the US) were successful in stimulating aggregate lending by Japanese banks, earlier blanket infusions (comparable to the 2008 Troubled Asset Relief Program (TARP) in the US) were not effective. Moreover, changes in accounting rules in Japan that revalued bank assets (similar to the relaxation of mark-to-market requirements for banks in the US) did not increase aggregate Japanese bank lending, but rather reallocated it. Capital constraints during the crisis also induced many Japanese banks to close their overseas branches and switch their charters from international to domestic. This endogenous charter switch reversed the process of foreign direct investment (FDI) for many Japanese banks. Therefore we use the Japanese banking crisis as a natural experiment to test FDI theories and find empirical support for the relative access hypothesis, but not for the industrial organization approach or for the relative wealth hypothesis.

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Notes

  1. Hoshi and Kashyap (2010) provide an in-depth analysis of the nature of the crises, showing that the parallel between the two crises extends beyond their initial roots in the real estate sector.

  2. We believe that both the Japanese and US crises were global in scope, in part because the US and Japan are the two largest economies in the world. Moreover, the process of Japanese bank charter switching spread the real banking effects of the crisis from Japan to the rest of the world via the closing of Japanese bank branches abroad. This global view of Japan's lost decade is supported by Peek and Rosengren (2000), who show that reductions in Japanese bank lending activity in the US during the lost decade had a detrimental impact on real economic activity in the US. However, the lessons from the Japanese crisis may not be directly applicable to the 2007–2009 crisis, given its extraordinarily broad scope, which even spread to low-income countries that were not integrated into the global financial economy.

  3. Although Japan's real estate bubble burst in the early 1990s, Japanese public policy interventions began in earnest only in 1998. Similarly, although the US banking crisis began in 2007, we consider the policies undertaken in 2008 and 2009, after it became obvious that other policies (such as liquidity provision) were not remedying the crisis.

  4. In 1998, each of the 12 major Japanese city banks received 100 billion in capital infusions, whereas in 2008 each of 25 large US financial firms received $25 billion in the initial TARP allocations.

  5. For details, see FAS 157–4: Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.

  6. Moreover, these studies did not utilize our disaggregated bank database. In fact, Giannetti and Simonov (2009) utilize an event study methodology that does not take into account the size and source of each public injection of capital.

  7. Capital costs are affected by frictions such as the tax subsidy of debt (Smith & Stulz, 1985), managerial risk aversion under asymmetric information (Breeden & Viswanathan, 1990; DeMarzo & Duffie, 1995), the classic debt overhang problem (Myers, 1977), and collateral constraints (Kehoe & Levine, 1993; Rampini & Viswanathan, 2010). These frictions are exacerbated for opaque banking firms with access to a government safety net from deposit insurance, lender of last resort privileges and TBTF bailout protection. Allen et al. (2010) find that increases in aggregate levels of bank risk taking increase fundamental economic and financial uncertainty, which increase the cost of capital during crises.

  8. For examples of empirical studies examining international acquisitions, see Ahuja and Katila (2004), Allen and Pantzalis (1996), Anand and Delios (2002), Dunning and Narula (1996), Ghemawat (2003), Kipping (1999), Reuer, Shenkar, and Ragozzino (2004), Tschoegl (2002), and Wilkins (1990). A notable exception is Klein et al. (2002), which attributes the decline in Japanese investments in the US to changes in real foreign exchange rates.

  9. Kang and Stulz (2000) attribute the loss of more than half of equity value for the typical firm on the Tokyo Stock Exchange during 1990–1993 to the banking crisis.

  10. The dichotomization of Japanese banking into international and domestic may have been encouraged by the original Basel Accord signed in 1988. A major objective of Basel I was to level the international playing field, in direct response to the perceived lower capital requirements for Japanese banks, which presumably gave them a competitive advantage. Since this did not apply to Japanese banks that had only domestic operations, the Ministry of Finance allowed them to retain lower capital requirements in exchange for a ban on international operations, whereas international banks had to comply with higher Basel capital requirements. However, even prior to the adoption of the Basel capital requirements, international Japanese banks were required to hold more capital than domestic banks. Their minimum ratio was set at 6% of total assets, as compared with 4% for domestic banks. However, only international banks were allowed to use 70% of unrealized gains on equity securities (so-called hidden reserves, or the equity revaluation allowance) in order to meet their capital requirements. According to Himino (2005), Japan's international (city) banks were dependent upon their hidden reserves to meet the 6% capital requirement. Dichotomous capital regulations were adopted by the Basel Committee in November 2010, and domestic banks without cross-border operations were exempted from new higher capital requirements.

  11. Hoshi, Kashyap, and Scharfstein (1991) and Uchida and Nakagawa (2007) find evidence of irrational herding behavior among Japanese banks in the domestic loan market during the buildup of the credit bubble in Japan during 1987–1989.

  12. However, Bayazitova and Shivdasani (2009) show that TARP infusions had a positive impact on the equity valuations of recipient banks, particularly for the large banks that were the first to receive capital infusions.

  13. The Basel Capital Accords specify that banks must hold both Tier 1 capital, comprising mostly bank equity, and Tier 2 capital, comprising preferred stock, long-term subordinated debt, up to 1.25% in the form of general loan loss provisions, and the revaluations permitted to Japanese banks.

  14. Land revaluation allowances apply to land owned for business purposes, that is, occupied by buildings, employee housing and held for employees’ welfare.

  15. Banks had the discretion to choose whether or not to declare an allowance for land revaluation. Therefore there were no instances of negative land revaluation allowances as of the regulatory date of revaluation.

  16. In our sample period, only one bank, Mizuho Bank (formerly known as Yasuda Trust), switched in March 2003 from domestic to international, but this was in the context of a general reorganization and consolidation of its domestic and international divisions.

  17. There are two groups of regional banks. Regional 2 banks were originally established as mutual banks, and were regulated separately from regional 1 banks in Japan. On 1 February 1989, 52 of 68 mutual banks were transformed to Banking Act regional banks and designated regional 2 banks. By 1 April 1992, all remaining mutual banks had completed their transformations to regional 2 banks under the Banking Act.

  18. Because of the absence of data on new lending flows, we utilize the net change in outstanding loans in our analysis. Note that the relationship between change in outstanding loans and new loans can be expressed as New loans=Change in outstanding loans+Charge-offs+Transfer of real estate loans to other real estate owned due to foreclosures+Loan sales (refer to Peek and Rosengren, 2000, for details).

  19. Another difference between direct public injections and the revaluation allowances is that the latter represented permanent, ongoing infusions, whereas the public capital infusions were one-time episodes. Moreover, land revaluations were permanent infusions (until the land was sold and removed from the bank's books), whereas equity revaluations were revised each year, based on share prices.

  20. The RISKBASEDPUBINJ independent variable is measured as a proportion of the log of total assets. From Table 2, the average of the 1og of total assets in our sample is 14.57, implying an average asset size of 6.84 trillion. Multiplying the average asset size to the coefficient estimate (0.0104) times the average rate of risk-based capital injections (0.025%) yields an average increase in total lending of 17.77 million per bank related to the risk-based capital injections, which implies an average increase in bank loans by 2.6% of an average bank's assets in our sample. If we consider only those banks that received a positive infusion of risk-based capital, then their average increase in loans amounts to 3.86% of their assets.

  21. Multiplying the coefficient estimate (−0.0424) by the average rate of blanket capital infusions (0.003%) times the average asset size (6.84 trillion) yields an average decrease in aggregate lending of 8.69 million per bank, which implies an average decline in loans of 1.27% of assets. For banks that receive positive blanket infusions of capital, the average decline in loans is 1.74% of bank assets.

  22. This sectoral reallocation of loans is consistent with the debt concentration effect postulated by Gande, John, and Senbet (2008).

  23. BISDIF measures the overall capital effect in terms of the bank's deviation from Basel capital requirements. However, because BISDIF is positively correlated with the amount of commercial and industrial loans (see Table 4), we cannot use it as an instrumental variable.

  24. We thank Professor William Greene for suggesting this methodology.

  25. We performed a similar decomposition of our sample into regional banks only, and according to whether a bank received one type of capital infusion, but not the other, and obtained results similar to those presented in Table 6. In particular, our results are consistent with a retrenchment in lending activity by troubled regional banks that are more likely to switch charters in response to capital constraints. Results are available upon request.

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Acknowledgements

We are greatly indebted to the editor, Lemma Senbet, and three anonymous referees for their insightful comments. We also appreciate the comments of: Joe Peek, Takeo Hoshi, Hirofumi Uchida, Masami Imai, Thomas Philippon, Hamid Mehran, Stavros Peristiani, Richard Startz, William Greene, as well as the seminar participants at the NBER Japan Project Meeting Tokyo, the NYU-NY Fed 2009 Seminar, the June 2010 BIS Workshop organized by Basel Committee on Banking Supervision, the Centre for Economic Policy Research (CEPR) and the Journal of Financial Intermediation, the European Financial Management Association Annual Meetings 2010, the American Law and Economic Association Annual Conference 2010, the Midwest Macroeconomics Meetings 2010, the Macro Colloquium, Graduate Center CUNY, the North East Universities Development Consortium (NEUDC) 2010 at MIT, Rutgers University and Eastern Economic Association Annual Meetings 2011. Chakraborty gratefully acknowledges financial support from the PSC-CUNY Research Foundation (Grant No. 62801-00 40). Watanabe gratefully acknowledges the financial support from the Japan Society for the Promotion of Science, Grants-in-aid for Young Scientists (B 18730207) and the Keio/Kyoto Global Center of Excellence Program. We also thank Akio Ino and Taisuke Ogawa for their excellent research assistance.

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Authors and Affiliations

  1. Bert W. Wasserman Department of Economics and Finance, Baruch College, City University of New York, USA

    Linda Allen & Suparna Chakraborty

  2. Faculty of Business and Commerce, Keio University, Tokyo, Japan

    Wako Watanabe

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  1. Linda Allen
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Accepted by Lemma Senbet, Area Editor, 31 January 2011. This paper has been with the authors for two revisions.

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Allen, L., Chakraborty, S. & Watanabe, W. Foreign direct investment and regulatory remedies for banking crises: Lessons from Japan. J Int Bus Stud 42, 875–893 (2011). https://doi.org/10.1057/jibs.2011.17

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