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Banking Biohazard: Zombie Banks, Toxic Assets and How the US Can Learn from Japan

Introduction and Background The goal of my research is to gain a deeper understanding of how the lessons of the Japanese banking crisis in the 1990s apply to America’s crisis today. I propose constructing a timeline of unsustainable business actions taken by “too-big-to-fail” financial institutions that ultimately failed in Japan’s financial crisis, including Long-Term Credit Bank of Japan, Hokkaido Takushoku Bank, Nippon Credit and Yamaichi Securities. Study in this area will inform research on the US’s recovery, Japan’s return to economic growth and the resolution of future financial crises.

Throughout the current financial collapse, leading national voices have declared that the US needs to learn from Japan’s experience in the 1990s.1 The lessons listed—the need for quicker monetary easing, a clean-up of insolvent banks, and greater accounting transparency—are certainly worth heeding. However, even though Japan did lower interest rates, resolve undercapitalized banks and clean up accounting standards, Japanese banks remained consistently unprofitable. So, are there other lessons we need to learn?

I believe that one driving force behind Japan’s financial malaise was a failure to resolve obviously unhealthy banks. Then as now, bank health is often measured by self-reported regulatory capital, but that metric alone says little about a bank’s damage to the greater system: it matters what a bank actually does. A “zombie bank” certainly hurts other banks when it ultimately fails (counterparty risk), but actions before then can be far more deleterious. Such banks engage in aggressive, unsustainable actions that crimp profit margins, introduce volatility, cloud the regulatory outlook and underprice risk.

A zombie bank is an otherwise insolvent institution reliant on government support, which undermines healthier banks (Kane 1993). Zombie banks make depositors skittish (sometimes enduring bank runs) and therefore pay higher deposit rates, which forces competitors to pay up as well.2 Zombie banks move into riskier asset classes to return themselves to solvency and may need to sell impaired assets at depressed prices, again forcing competition to accept lower returns. This lower-profit higher-risk infection causes insolvency to spread throughout the financial system, prolonging and intensifying banking crises.

Banks are supposed to act as the economy’s financial intermediaries, matching borrowers and lenders, and profiting when they take on risk. In a well-functioning economic system, banks contribute to economic growth by assessing risk well and lending responsibly to individuals and businesses. If that system is broken, achieving economic growth becomes very difficult.

1 For example, see economist Nouriel Roubini in The Financial Times (December 2, 2008), Pulitzer Prize winner David Sanger

in The New York Times (February 8, 2009), the print edition of The Economist (February 12, 2009), and Jane Sasseen and Theo Francis in Business Week (March 23, 2009).

2 Uninsured depositors are the usual suspects for modern US bank runs. However, despite the FDIC’s strong reputation,

federally insured depositors also withdrew billions in days from now-defunct IndyMac, Washington Mutual and Wachovia.

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Research Outline Table 1. Research Proposal Timeline *

Year Month Stage of Research Research

2009 Oct

Nov

Dec

2010 Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

2011 Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

2012 Jan

FebMar

* The above table assumes a 2-year course of study beginning in April 2010 but can be adjusted

according to the terms of the scholarship.

Collect Data

Finance & Accounting

Conduct Interviews

Write Paper

Review Findings

Publish

Work with advisor, other researchers to

understand certain accounting issues.

Gather additional data and writings on

events from 1989 - 1999.

In the US

In Japan

Interview managers in bank units:

underwriting and credit, asset-liability

management, structured products.

Interview regulators.

I: Japan in the 90s vs. US today

II: Methodology

III: Stages of the crisis and US progress

IV: Banks at risk and their risk to economy

V: Recommendations for action

VI: Areas for further research

Solicit feedback and finalize.

Preparation

Continue collection of data from public or

otherwise available sources (EDGAR, JBA,

MOF, Bloomberg, FOIA). Finish literature

review

Business/economics journal

Popular writing

Online

Preparation

I have already begun work on data collection (currently over 40 MB and 500,000 lines of raw numerical data) and have conducted an extensive literature review. While I cannot access Japanese researchers in person, I will continue this process and include full, recent financial statements for as many major US banks as possible to complement the time-series data I already have on Japanese banks.

Collect data

Once in Japan and with access to university library resources, professors and Japanese print resources (such as the National Diet Library), I will fill in any missing pieces in the data, such as early 1990s financial statements. I intend to minimize this process, but much of the information may be computer-inaccessible or be in Japanese and require longer reading time.

Finance & Accounting

I have several outstanding questions on accounting, for example on the impact of purchase accounting on the acquiree’s impaired loans (i.e. how to account for a company’s bad loans when it’s bought out), which can have

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an enormous impact on regulatory capital.3 My experience with Wells Fargo’s takeover of Wachovia is that management has discretion in applying unintuitive accounting standards that obscure underlying financial realities. Without extensive public disclosure or the ability to question a bank’s Treasury, understanding the risk profile is almost impossible.

Other issues include recognition of impaired assets, and generally how I can organize information in a way that will advance subsequent research.

Conduct interviews

I am intimately familiar with the liquidity, capital and lending concerns at Wells Fargo and former Wachovia and Golden West. I can leverage contacts to work with Citi, Bank of America and several regional banks. Therefore, my primary concern is access to veterans of the Japanese banking crisis, many of whom may be in different roles at this point, which requires research and trust-building with individuals and human resources departments for the legacy Hokkaido Takushoku Bank, Sanyo Securities, Long-Term Credit Bank and so forth. Today, banks such as Mitsubishi UFJ, Shinsei and Aozora may also be able to shed light on the difficulties they have had in restoring profitability.

Having worked with the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), I can say that regulators often have a very different perspective than bankers do. Most importantly, regulators make the ultimate decision on whether and when to shutter a bank. Therefore, it will be useful to work with those who closed insolvent institutions.

Write paper and review findings

I will dedicate a substantial amount of time to writing the paper and, as the need arises, go back to previous steps to enhance my knowledge and confidence. This process will also be subject to ongoing review from my research advisor and any interested researchers. Time set aside for final review is designed to clearly delineate where the work should enter its final stages.

Publish

I believe that research on this subject matter will be of interest to other researchers and financial practitioners. I will seek to publish findings where appropriate, such as in business journals, condensed for the popular press and online (from sources that are in the public domain or allow non-commercial/educational usage). Ultimately, my goal is to make the information user-friendly and easily accessible, because increasing transparency and knowledge is absolutely essential to a well-maintained financial system.

Other

Because of my experience working through Wachovia’s financial struggles, I can assist professors in banking research, especially regarding behavioral issues, regulatory developments and asset-liability management issues.

Most Japanese banking is centered in Tokyo, however, major bank failures occurred in areas such as Sapporo (Hokkaido Takushoku Bank), Kobe (Hyogo Bank) and Osaka (Kizu Credit Cooperative). I intend to travel when necessary to conduct the interview and data collection portions of my research plan.

Additionally, I intend to complete the final Chartered Financial Analyst exam in June 2010. The charter requires passage of three exams (200–250 study hours each) and four years of experience in finance (I have two). I have accounted for this commitment early in my timeline.

3 Purchase accounting, moreover, is an area where even financial news sources are notoriously unreliable. Ari Levy and

Elizabeth Hester severely misconstrue merger accounting in “JPMorgan’s WaMu Windfall Turns Bad Loans into Income,” Bloomberg, 25 May 2009, and, among others, NPR and the New York Times repeated the poor information the next day. The standard in question is AICPA Statement of Position 03-3, which details impaired loan purchase accounting.

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Why the Research Is Essential Having shown what and how I will research, I’d like to note why with an example.

Banks like Washington Mutual and Wachovia were technically well-capitalized until the day they failed. But in the many months leading up to that collapse, the two banks offered very high-rate (but nonetheless federally insured) deposits, forcing other banks to do the same. They stopped lending in late 2008 and began hoarding cash in early 2009, which hurt businesses and individuals dependent on credit. And the banks’ looming demises made the future uncertain for investors and businesses: Would the Treasury allow the two to go into bankruptcy like Lehman? Would subsidized merger deals arise, like with JPMorgan and Bear Stearns? Would they be nationalized like IndyMac? Would a suitor emerge, like when Bank of America bought Countrywide?

Add in the Citi vs. Wells Fargo fight for Wachovia, Morgan Stanley’s struggles and Lehman Brothers’ disorderly bankruptcy, and you have a financial world in panic. The Treasury calmed the seas via massive capital injections in all major banks. Then banks panicked again when concerns arose about Citi and Bank of America, and the public grew outraged over AIG.

The ebb and flow of sheer panic is not a coincidence. Regulators have taken an arbitrary, ad hoc approach, dealing with individual crises as they arise because they lack a way to definitively declare a bank unsound. Helping to develop a robust, forward-looking approach can determine how the US should look at remaining troubled banks. Otherwise, those institutions may present risks to even healthy banks, such as JPMorgan Chase, BB&T and Goldman Sachs (see table on page 5). As Peek and Rosengren point out about Japanese banks, “if [they] are no longer to be charged large premiums in the interbank market, investors must be convinced that concrete actions have been taken to eliminate those banks that are not competitive in a way that does not imperil the remaining healthier banks.”

Why the research should be done now

The most unusual aspect of Japan’s banking crisis is its length; crises such as those in Sweden and Norway were resolved in a few years (Basel 2004).

Research is also time-sensitive. After more than doubling the monetary base in less than a year, raising interest rates may not be enough if the risk of inflation grows. The Fed’s balance sheet includes a large proportion of illiquid asset-backed securities, so it may be difficult for the Fed to decrease the monetary base (Delta Global Advisors 2009). As PIMCO co-CEO El-Erian stated recently, “central banks and treasuries will find it difficult to undo smoothly some of the recent emergency steps, [which] is particularly consequential in countries, such as the U.K. and U.S., where many short-term policy imperatives materially conflict with medium-term ones.” Researching how to resolve these financial issues right now is essential.

Why the research should be done in Japan

Doing my research in Japan is essential to producing strong results. Non-Japanese lack the intimate familiarity with Japanese companies that I would find in Japan. Public information from two decades ago on Japanese companies is difficult to access from abroad and lacks context. The economists with whom I’d like to work have been involved in financial research for over twenty years. Treasury and risk managers will also be difficult to interview and work with from the US. By being in Japan, I can react quickly by being able to communicate in person and in the same time zone.

Additionally, the most valuable data (especially interviews and print-only resources) require a physical presence. Public data sources such as EDI-NET, Japan’s version of the SEC’s EDGAR database, lists only recent financial statements. Subscription services such as Teikoku Databank or FSA data can cost thousands of dollars. However, by belonging to a Japanese institution, I can have access to the wealth of information accessible to all of the university’s researchers. It is impractical to undertake research on 1990s Japan with insufficient access to that information.

I look forward to undertaking this research, and I believe it will be invaluable in helping the United States and Japan recover from their respective financial market difficulties.

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Table 2. Implications of Bank Stress Test: Ability to Issue Capital and Pay Back TARP Funds(balances in billions, data as of May 12, 2009 and adjusted for recent capital actions)

Ability to be well-capitalized without government

assistance Ability to issue debt Adjustments

Bank

TARP money

to repay 1New common

equity needed 1as a % of market

value of equity

Long-term

credit rating 35-year CDS

spread

GMAC 4 $ 5.1 13.4 N/A % CC 906 bpsCiti 46.4 33.4 164.7 A 361 SunTrust 4.9 7.1 121.9 BBB+KeyCorp 2.5 3.6 120.3 A-Regions 3.6 3.9 110.3 A+Fifth Third 3.5 4.6 96.5 A-Bank of America 45.4 65.0 83.5 A 188 PNC 7.8 7.7 39.2 AA-Morgan Stanley 10.4 11.0 34.8 A 258 Wells Fargo 25.9 26.1 22.1 AA 146 US Bank 6.8 3.4 11.0 AABB&T 3.2 1.3 10.3 AA-American Express 3.5 1.0 3.3 A- 298 Capital One 3.7 0.1 1.3 A- 217 MetLife - - - A 586 Bank of NY Mellon 3.1 - - AA-State Street 2.1 - - A+Goldman Sachs 10.5 - - A+ 176 JPMorgan Chase 25.9 - - AA- 122

= May be unable to raise sufficient capital or issue long-term debt without FDIC assistance. = Need to raise capital. = May be able to repay TARP immediately. Several firms have already raised non-FDIC-backed debt.

1 Initial investment amount plus value of warrants to purchase common stock, when possible based on Congressional Oversight Panel, Assessing Treasury’s Strategy: Six Months of TARP, April 2009.2 Estimate based on Supervisory Capital Assessment Program required capital buffer and TARP receipts.3 Simple average of applicable Moody's, Standard & Poors and Fitch long-term unsecured debt ratings.4 GMAC is privately held, therefore market value of equity and financial statements are unavailable.

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References Basel Committee on Banking Supervision. 2004. Bank failures in mature economies. Working paper, Bank for

International Settlements.

Board of Governors of the Federal Reserve System. 2009. The Supervisory Capital Assessment Program: Overview of results. May 7, http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf

Boyce, Alan. 2009. Alternative models for financing real estate markets. Presented at the Market & Liquidity Risk Management for Financial Institutions, May 4, 2009, in Arlington, Virginia.

Delta Global Advisors. 2009. Ben’s un-shrinkable balance sheet. April 14.

Kane, Edward J. 1993. What lessons should Japan learn from the U.S. deposit insurance mess?. Journal of Japanese and International Economics 7: 329–355.

McKelvey, Bryan. 2007. Business effects on migrant labor policy formation in Japan. Honors thesis, University of North Carolina.

Peek, Joe and Eric S. Rosengren. 2001. Determinants of the Japan premium: Actions speak louder than words. Journal of International Economics 53, no. 2: 283–305.

Whalen, Christopher. 2009. Can Citigroup be restructured without an FDIC resolution? The Institutional Risk Analyst, April 17.