1996 Reports

Japanese banks' bad loans: What happened?

Marsh, Terry A.; Paul, Jean-Michel

In this paper we trace the increase in Japanese banks' loan spreads and ex ante riskiness of their loan portfolios in the late 1980s and early 1990s. We show that within the three sets of city, trust, and long-term banks, the banks with the highest late-1980s capital deficiencies vis-a-vis the then-impending BIS capital standards had the highest growth rates in risky lending. They also had the highest short-term growth rates in retained earnings which count as Tier I capital. We describe how banks were led to enhance their BIS capital ratios in this way because of the inflexible loan loss provisioning and write-off procedures they faced in Japan. Taken together, the events illustrate the perils of partial regulatory change, whether in the process of deregulation or "new-regulation" as the BIS standards were, when the affected regulations are part of an inter-related system of regulations, incentives, and economic agents' decision rules.