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The Safety Net after April 2001

Excerpt from "Preparing for the Coming Century," a Speech by Sakuya Fujiwara, Deputy Governor of the Bank of Japan, at "Keizai-kurabu" on July 29, 1999

July 29, 1999
Bank of Japan

I would like to talk about the deposit insurance system after April 2001, often referred to as the "Year 2001 Problem" or "Payoff Problem" in the media. The subject has only started to be discussed on a full scale, and the Bank of Japan does not have concrete proposals on this matter yet. However, I would like to share with you some issues that we have in mind at the moment.

Financial System Problems in Recent Years and Measures to Cope with Them

The present Japanese safety net measures are probably all that can be desired to prevent financial system instability when a bank fails. First, I would like to review how the safety net has been developed.

The Japanese deposit insurance system was established in 1971. At the beginning, the system's sole function was to "payoff" deposits, in other words to pay insurance up to a million yen. In 1974, this limit was raised to 3 million yen and then in 1986 to 10 million yen. At the same time, the Deposit Insurance Corporation (DIC) was authorized to make loans or contributions to facilitate mergers and the transfer of business of failed financial institutions. Later, as seen in the examples of the Tokyo Kyowa and Anzen credit cooperatives, in December 1994, the successive failure of small and medium-sized financial institutions materialized because of the bursting of the bubble economy. To cope with the situation, in June 1996, the DIC was authorized to extend "special financial assistance" in order to protect deposits and other liabilities in full until the end of March 2001. However, the Japanese financial system encountered a serious crisis when major financial institutions such as Yamaichi Securities and Hokkaido Takushoku Bank failed in November 1997, and the Japan premium jumped in overseas markets. To respond to the worsening situation, in February 1998, the Diet authorized an appropriation totaling 30 trillion yen for the disposal of failed banks and recapitalization of viable banks. Moreover, in October 1998, the Financial Reconstruction Law and the Financial Function Early Strengthening Law were enacted, providing a framework of failure resolution including temporary nationalization and placement under the Financial Reorganization Administrator, as well as a framework for the recapitalization of financial institutions with public funds. The DIC was provided with the necessary financial resources for the full protection of depositors, with public funds allocated for that purpose being doubled to 60 trillion yen. Under this framework, the Long-Term Credit Bank of Japan and the Nippon Credit Bank were placed under state control. And, in March 1999, public funds totaling 7.5 trillion yen were injected into major banks in order to enhance their capital base.

Assessment of the Present Regime and Need for Change

Due to these decisive actions by the authorities and own efforts on the part of individual banks, I believe the uncertainty surrounding the financial system has been fading gradually. In this sense, I consider the measures being taken are necessary and justifiable, if not desirable, with a view to maintaining the stability of the financial system. However, these exceptional measures; especially the one that repays all the liabilities of failed banks, is costly as it is effective taxpayers are the ones who share the this cost. Naturally, this gives rise to moral hazard. That is, financial institutions are not sufficiently monitored by depositors and markets, because it makes no difference which institution they choose if all liabilities are protected. It should be noted that self-responsibility and market discipline are basic principles behind the Big Bang in Japan. Therefore, there seem to exist problems in keeping such emergency measures as protecting all the liabilities of banks for a long time.

Lifting the Moratorium on "Payoff"

As we near the expiration of the exceptional measures in March 2001, debate on whether or not to lift the moratorium on payoff is drawing public attention. Yet it seems that even those who disagree with the lifting the moratorium do not believe unlimited protection should be permanent. In other words, they are of the view that, when the financial system is extremely unstable, comprehensive protection measures are necessary, and that confidence in the financial system may not be fully restored by March 2001 to allow repeal of the current protection measures. This subject as well as the framework of the future safety net is for the public to decide. However, we believe it most important to make best efforts to restore confidence in the financial system within the remaining one and a half years, making use of the currently available framework. And to make such efforts effective, "easy prolongation of the exceptional measures" would not be desirable.

In addition, designing a safety net for after the abolition of exceptional measures is also an important issue. The Financial Council of the Ministry of Finance has been working on this matter, and on July 6th it published an interim paper. The paper itself does not suggest any particular direction for discussion, but simply lists specific issues that need to be thoroughly considered together with conflicting opinions on each issue. The issues are wide ranging, and demand difficult judgments before reaching conclusions. However, since the issue of designing a new safety net concerns all depositors, that is, the whole nation, it is important to make public as soon as possible the outline of the new framework based on wide discussions.

A New Framework of Failed Bank Disposals

Such is the discussion on the new safety net under way. At this stage, there are some points I would like to mention.

First of all, depositors should understand that lifting of the moratorium on "payoff" means abolishing the exceptional measures that are applied at present to protect all liabilities. It does not mean that the "payoff" or literally liquidating failed banks, is applied in all cases. In fact, in the U.S. and Europe, literal "payoff" is considered as the most costly way of disposing of failed banks both socially and economically and is applied only in exceptional cases. Thus, the most frequently used resolution method is the business transfer, where a part or all of the business of the failed bank is transferred to a healthy bank. During this process, depositors and other creditors may be made to share a proportion of the loss.

In this sense, it is necessary to clarify what it means to lift the moratorium on "payoff" so that the word should not unnecessarily make people nervous. In fact, this does not necessarily mean that all failed banks disappear after deposit insurance is paid out to depositors. More precisely, it means that, as a result of the abolition of the exceptional measures, the government and the Deposit Insurance Corporation will not assume all losses of the failed banks, and thus depositors and claimants too would share appropriate losses.

The next thing I would like to clarify is that although it is stressed that deposits are protected up to 10 million yen, whether the failed bank is disposed of by "payoff" or business transfer, this does not mean that amounts exceeding 10 million yen will be entirely lost.

The phrase "amounts exceeding 10 million yen will not be protected" is seemingly causing significant misunderstanding. In reality, amounts exceeding 10 million yen will be repaid on a pro rata basis from recovery of the failed bank's assets through the liquidation process just as in ordinary bankruptcy cases. In addition, the Deposit Insurance Corporation is authorized to make early repayment on the amount of deposits exceeding 10 million yen by purchasing them from the depositors of the failed bank at an estimated liquidation value, and therefore the depositors do not have to wait for the liquidation process to be completed. For example, if the liquidation value is estimated to be 80% of book value, 80% of the amount exceeding 10 million yen will be repaid at an earlier stage. Of course this percentage is a mere example, and it really depends on each case.

Third, the trouble entailed by a bank failure is not limited to the burden on the depositors that deposits are not repaid in full. When a bank fails, the operations of the bank, including acceptance and payment of deposits, would practically be disrupted for a certain period under the present deposit insurance system. Under the present deposit insurance system, insurance is applied per depositor, not per account. That is, when an individual or company has several accounts in the failed bank, balances of all such accounts have to be aggregated to determine the insured amount. This is a very time-consuming process. Moreover, when haircutting the deposits and other claims in proportion to the value of the failed bank's assets, time-consuming procedures, such as obtaining the consent of claimants, are unavoidable. As a result, payment of insurance and liquidation proceeds, in spite of all efforts to be quick, could require a significant period of time. In such circumstances, the depositors of the failed bank will not be able to withdraw their deposits until they receive the advance payment of liquidation proceeds, and the borrowers also have to find another financial institution to fund their business. In the worst case, individuals could be short of funds for living expenses. Unable to meet daily settlement obligations, small businesses could be brought to a standstill for lack of liquidity.

Therefore, one of the most important points concerning the future safety net seems to be how to ensure swift resolution.

As I mentioned earlier, in overseas cases instead of literally wiping out failed banks, it seems necessary to have in place other alternatives which, for example, preserve financial functions needed in local areas. Specifically, it seems necessary to introduce a method where deposits and loans of failed banks are transferred to other sound banks in a prompt manner. Here, promptness is the key.

This is easier said than done. In order to introduce such a method, several complicated legal and practical problems have to be solved. These problems are the major issues being discussed in the Financial Council.

In this sense, the "P&A" (purchase and assumption) employed by the Federal Deposit Insurance Corporation of the U.S. may be suggestive. Precisely, P&A means to "purchase assets and assume liabilities." In P&A, the failed bank is closed on a Friday after business hours, and over the weekend, deposits are grouped by name, excess claims haircut, and a portion of assets and liabilities transferred to the assuming bank. Such prompt resolution requires preparatory work and the appropriate legal framework. If this method can be introduced in Japan, business operations of the failed bank would not be disrupted on a business day.

I am not saying that our failure resolution method should transplant the U.S. style in every respect. As a matter of fact, legal and practical differences between the U.S. and Japan make it impossible. We just need to make efforts to get over the legal and practical difficulties involved and devise a prompt way to dispose of failed banks while referring to the experiences of other countries such as the U.S.

So far, I have covered various points in relation to the framework of the new safety net. However, what is most important is to prevent banks from failing, and, if a failure does occur, to resolve it at an early stage before the losses become too large. In short, it is desirable to foster sound management of financial institutions so that deposit insurance does not have to be called upon. But, if it has to be utilized, disposals should be made before the cost to the insurance fund becomes too large. Such prompt action will be indispensable in minimizing the cost for the maintenance of financial system stability.

Giving due consideration to these points, we would like to contribute to the work under way to establish a new framework for the future safety net.