The Rise and Fall of Bank-Loan Capitalism: Institutionally Driven Growth and Crisis in Japan

Abstract

(printed cbl-5) (wrd doc en compu) Ozawa, Terutomo, "The rise and fall of bank-loan capitalism: Institutionally driven growth and crisis in Japan", Journal of Economic Issues; Vol. 33, Issue 2, Lincoln, June 1999, pp. 351-358 Abstract: Alexander Gerschenkron (1962) observed that developing countries, as late-comers to industrialization, tended to become reliant on institutional arrangements other than the market, especially in their efforts to finance their catch-up industrialization. Japan's catch-up growth was facilitated by central bank-based finance in which the major banks played a pivotal role in financing capital formation in collaboration with their keiretsu groups. The building-up of capital-intensive, scale-driven heavy and chemical industries in the early postwar period entailed high financial risks that might have discouraged the private sector from investing in them. The social benefits of industrial modernization far exceeded the private benefits. Risk-taking inducement was thus socially justified. Moral hazard was thus taken advantage of to encourage the private sector to move into capital-intensive growth industries. In any market economy, banks play a key role in money creation and investment. They are the single most important intermediary for indirect finance across the world. The securities (such as stocks and bonds) market is also another ubiquitous presence for direct finance. The latter, however, normally develops and gains in importance pari passu with economic development; in general, the higher the per capita income, the greater the role of securities (vis-a-vis bank loans) as a source of external funds for business investment Levine 1997. Securities involve greater financial risks than bank loans. The American economy has become more dependent on securities than on bank loans for business finance. 1 In large measure because of pension funds and mutual funds, more than half of American households are estimated to be shareholders in one way or another.2 America's financial industry is the world's undisputed leader in innovations in the areas of derivatives and securitization, all adding to the rapid growth of the securities market. In these respects, American capitalism can be appropriately called "securities-market capitalism." In contrast, Japan's financial industry, although it was actually remodeled on the American system after World War II, has been sui generis in many respects. It is dominated by banks to such an extent that Japanese-style capitalism can be characterized as "bank-loan capitalism," especially in light of the relatively insignificant role played by the corporate bond market. Bank loans have been critical in financing Japan's phenomenal economic growth in the postwar period-and ironically, because of this importance of the banking sector, the entire Japanese economy was affected all the more during the recent banking crisis and severe credit crunch. Bank-Loan Capitalism Any rapidly developing economy requires increased finance. How to organize this is a critical issue in formulating a successful strategy for rapid industrialization. In essence, two possible solutions exist. One is to borrow from overseas by running a current-account (CA) deficit (since CA = domestic savings - domestic expenditures). This, however, makes a debtor country vulnerable to the vagaries of hot global money, as has been so painfully experienced by beleaguered emerging economies in the present global financial crisis. The other is to create credit internally through a country's banking system with the help of its central bank. This second approach is self-reliant in development finance and allows the country freedom from dependence on foreign capital. The first approach may be identified as "CA deficit-based finance," and the second as "central bank-based finance" Ozawa 1998. Japan has relied more heavily on the second approach by minimizing borrowing from overseas. It also promoted domestic savings as much as possible in part to enhance bank liquidity. In fact, this self-reliant approach of financing economic development has been an ingrained policy ever since the start of Japan's modernization in the mid-nineteenth century.3 In reconstructing its war-torn economy after World War II, Japan pursued central bank-based finance. The only way for Japan to create loanable funds without much borrowing from overseas was to make the most of the banking industry's credit-creating capacity with the help of its central bank. As is well known, the banking industry can create demand deposits (bank money) by a multiple out of any initial injection of liquidity into banks' reserves, a phenomenon known as bank money multiplication under a fractional reserve requirement.4 The discount window is another channel through which additional liquidity can be created. The reserve requirement may also be lowered to allow the banks to have excess reserves. All these liquidity-creating facilities can be extended for the purpose of providing long-term credit for capital formation in the course of industrialization. Central bank-based finance, however, entails the risk of inflation if expanded credit is used for nonproductive purposes such as consumption and speculative investments. Therefore, it requires proper guidance and judicious supervision of the banking industry by both the government and the central bank involved. There are two other methods of financing capital formation for economic development: (1) selling equities (stocks) and (2) borrowing by issuing debt instruments (bonds and other securities). These two alternatives lead to the growth of the securities market. In the early postwar period, the stock market initially played a relatively important role as a source of funds for corporate investment in Japan, but it soon came to be overwhelmed by bank loans. This was clearly reflected in the ever-declining equity-to-total-capital ratio throughout Japan's high-growth era (1950-1974); for all industries, it declined from 26.9 percent in 1950 to 16.1 percent in 1970, and for the manufacturing sector, it decreased from 31.4 percent to 19.9 percent over the same period Caves and Uekusa 1976, 479. In order to control credit expansion, the government prohibited corporations from issuing bonds. A bond-issuing privilege was granted only to those policy-purpose financial institutions (mainly, three long-term credit banks and utilities) that the government specifically created to finance infrastructural facilities and services. Under central bank-based finance, the Bank of Japan (BOJ) pumped reserves into Japan's major city banks, which in turn extended industrial loans to their own groups of closely affiliated corporations, the groups known as the bank-led kinyu keiretsu (financial conglomerates). There were six such major kinyu keiretsu that competed vigorously in arranging a set of heavy and chemical industries (such as steel mills, petrochemical complexes, heavy machinery shops, and shipyards).5 This kinyu keiretsu is also known as the "main bank" system Aoki and Patrick 1994. Consequently, two peculiar monetary phenomena came to be observed in Japan: a high dependence for liquidity of commercial banks on the BOJ, which came to be described as a "system of overloan (or overlending)," and an in-tandem dependence of the corporate sector on the city banks, which was called "overborrowing." Overlending describes a situation in which banks extended more loans than justified by the funds they received from depositors or investors, since banks' lending capacity was augmented by additional liquidity from the BOJ. Overborrowing means a condition in which corporations heavily depended on borrowing from their major banks-more heavily than from any other sources-for funds Suzuki 1987. Overlending and overborrowing were two of the distinct features of Japan's bank-loan capitalism Ozawa and Hine 1993. It may not be amiss to say that the BOJ was not a passive lender of last resort as a central bank (as described in a standard Western textbook); on the contrary, it was, indeed, an active lender of first resort. In addition, Japan's postal savings program played a key role in financial intermediation. During the high-growth period of 1950-1973, nearly one-third of total private savings was captured by the government in the form of postal savings accounts. In fact, Japan's postal savings system may be aptly called "the world's largest bank" Brown 1986, 128. It has more than 20,000 post offices throughout Japan, many of which are in rural agricultural regions. This means that "there are more postal savings windows than in all the branches of Japan's city banks combined" Brown 1986, 128.6 Under heavy regulations and controls, Japan's banking institutions were also compartmentalized into specialized activities and markets (e.g., separation of the lending business from underwriting of, and trading in, securities and the trust business; separation of short- and long-term finance; separation of markets by size of customers via a two-tier banking system of city and local banks) in order to channel funds into specific areas. Three long-term credit banks7 were created for the specific purpose of promoting the development of capital-intensive heavy and chemical industries. These banks were authorized to issue debentures (bonds) to raise funds, but these debentures were not purchased by the public at large: . . the debentures were allocated to city banks at below-market interest rates. BOJ credit was then used to subsidize the city banks. Throughout the high growth period, the official BOJ discount was kept lower than the interbank deposit rate (the call loan rate). BOJ loans were rationed to banks, city banks being the exclusive recipients, and this was a major tool of base money control Teranishi 1994, 33; emphasis added. Thus, both allocation and rationing measures were used in bank lending by the govern

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