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Insights into the Low Profitability of Japanese Banks:Some Lessons from the Analysis of Trends in Banks' Margins

November 2001
Tsuyoshi Oyama
Tetsuya Shiratori

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1. Developments in overall margins of Japanese banks have shown no major change during the last twenty years: a slight contraction in the early 1980s, followed by a discrete expansion during the bubble period, have only served to highlight their extreme stability. Meanwhile, net overall margins after considering loan-losses have been negative since fiscal 1993 as overall margins failed to respond to soaring loan-losses.

2. By dividing overall margins into the lending spread and the fund-raising spread, we find that the fund-raising spread contracted considerably from the 1980s to the 1990s while the lending spread expanded considerably during the same period. The change in fund-raising spread is attributable to two factors: a decline in so-called "rent" owing to deregulation of deposit interest rates since the middle of the 1980s and a fall in market interest rates to close to zero. Meanwhile, the change in lending spread is partly attributable to a rising consciousness of credit risk among banks since the early 1990s. The expansion of lending spread, however, has only offset the contraction of fund-raising spread and stopped short of covering loan losses, suggesting that banks regarded soaring credit costs since the early 1990s as temporary losses to be covered by capital, not as current losses to be covered by overall margins.

3. The pricing behavior of Japanese banks is closely related to relationship banking, or their behavioral features that greatly count the middle or long-term relationship with borrowers. The main characteristics of this relationship banking are that: (1) it reduces agency costs; (2) it smooths the impact on borrowers of the business cycle; (3) a real estate collateral is extensively utilized; and (4) programs of action are occasionally worked out to resolve the problems of financially troubled borrowers. These characteristics are thought to have held down both the level and fluctuation of overall margins for a long time in Japan.

4. The external environment that had supported relationship banking, however, has changed dramatically since the late 1980s. The changes include a significant decline in the cost of production of information on credit risk due to the financial deregulation and innovation in information technology, an increase in uncertainty about the business cycle, a constant decline in land prices, and an increasing difficulty in restraining moral hazard through the traditional regulation system. Thus Japanese banks' behavioral features, which once worked quite efficiently, have been gradually losing their basis in reality and banks' delayed responses to the above changes have led to today's low profitability.

5. In order to improve the profitability of Japanese banks, therefore, they first need to reassess their risk-taking and associated return on assets, explicitly considering the above -mentioned changes in business environment. Then, they need to cut drastically those assets whose risk is not manageable or cannot be justified by the returns and at the same time expand the range of risk they can manage. In other words, banks should (1) improve profitability by pricing loans consciously to cover the increased risk due to the changes in the business environment and by restructuring their balance sheets; (2) expand their playable market, which has been contracting due to the decrease in the production costs of information on credit risk and the increase in the average level of risk, by improving their information producing function (i.e. screening and monitoring of credit risk); and (3) improve their corporate governance by increasing their exposure to market discipline and thereby increase the effectiveness of (1) and (2) above.

6. It is also necessary to adapt Japan's financial system to the new environment so as to make it easier for banks to improve their profitability. Specific measures to be considered include (1) a reduction of the presence of public financial institutions; (2) easing of the "over-banking" situation; (3) improvement of corporate governance structure and of the system to restrain moral hazard; and (4) institutional support to smooth the reallocation of managerial resources.