Through most of the 1990s and early 2000s, Japan grappled with a financial crisis whose origins were in some ways similar to the turmoil afflicting the United States today. The storyline from a decade and a half ago in the world's second largest economy evokes an unmistakable sense of déjà vu: the bursting of a property bubble fueled by excess liquidity, lax financial regulation, and over-optimistic projections of asset prices precipitating a real estate and banking crisis. Compared with the fallout and policy response over the past year, events were considerably more drawn out in Japan. Although the bursting of the bubble in Japan left the financial system saddled with large nonperforming loans (NPLs) and weakened the economy significantly, it took a while before the full scale of the problems became evident.
In 1997, six years into Japan's problems, mounting losses on failed real estate loans and falling share prices led to the interbank market freezing up and a wave of failures in the financial sector, featuring some of the country's largest banks. Faced with a financial system paralysis that threatened to undermine the entire economy, the Bank of Japan (BoJ) scrambled to unlock credit markets. The government also orchestrated large-scale interventions with public funds, struggling with a now-familiar dilemma: how to promote orderly deleveraging while minimizing costs to the taxpayer and limiting moral hazard. In Japan's case, the crisis was successfully resolved, but not before a "lost decade" of economic stagnation and a prolonged bout of deflation.
If anything, today's crisis appears more daunting, given its global scope, the complexity of the distressed instruments involved, and the much weaker international setting. Highly leveraged financial institutions have been joined by highly indebted households this time around, compounding the weakness in domestic balance sheets. Nevertheless, both crises were grounded in broadly common ills, so that Japan's eventual success-and early difficulties-in overcoming its challenges are likely to provide useful insights.
Reflecting the breadth and gradual unfolding of the crisis, Japan's strategy evolved over a number of years, at first centering on innovative and exceptional measures by the BoJ to provide liquidity, including expanding the range of collateral, direct purchases of assets, and quantitative easing under a zero-interest-rate policy. While necessary, this liquidity provision proved insufficient for fixing the financial system. When the crisis intensified, the authorities turned to restructuring banks, pushing them to recognize problem loans and raise new capital, and in some cases seek out public funds or exit the sector. In the end, tighter supervision, judicious use of public funds, and a sound framework for restructuring distressed assets helped restore health to the financial system. At over ¥100 trillion (about $1 trillion), bank losses were much larger than first envisioned, and about ¥47 trillion in public funds was eventually needed to dispose of NPLs and recapitalize banks. However, nearly three-fourths of these funds have since been recovered.
Encouragingly, the initial reaction to the current crisis has been swift and forceful, featuring several steps to address liquidity stresses in interbank markets and the passage of a publicly funded bailout package. All in all, the United States has so far moved with commendable alacrity: in Japan, it was not until 1999-eight years into the real estate bust-that a full-scale injection of taxpayer funds was committed to a comprehensive financial overhaul.
But where do we go from here? U.S. financial markets remain severely strained and fears of a grim recession loom. If Japanese history is any guide, some of the most difficult steps may be yet to come. Although much energy has so far been devoted to bank liabilities (protecting deposits and supporting borrowing), a comprehensive strategy to address the broader challenges-restructuring troubled assets and facilitating consolidation-has yet to be fully fleshed out.
For a sustained recovery, nothing short of a systemic solution that addresses both sides of the balance sheet will do. In Japan's case, a comprehensive approach that addressed both solvency and liquidity issues in the banking system proved to be most effective in resolving the crisis. Measures included recapitalizing the banks and restructuring the debts of the corporate sector. Some potentially useful lessons are suggested by Japan's strategy.
o Liquidity provision helped forestall an immediate systemic crisis, but did not adequately address the fundamental problem of an undercapitalized banking system. Ample liquidity is part of the solution, but without steps to fully recognize losses and address the capital shortage, the functioning of the markets can be distorted and delay needed restructuring. Weak accounting practices and regulatory forbearance masked the NPL problem for many years and limited incentives for action, such as seeking out new capital or merging with other institutions. The delay in recognizing the losses proved extremely costly, allowing insolvent "zombie" companies to linger. Today, global losses on securitized debt originating in the United States are estimated by the IMF at about $1.4 trillion. Only about half have so far been written down. More transparent regulatory structures based on fair market valuation that encourage banks to repair their balance sheets could assist. At a minimum, early action to recognize losses and raise adequate provisioning could help nail down capital shortages and kick-start the process of restructuring.