Japan's Lost Decade and its Financial System

After briefly explaining the causes of the Japanese asset‐price bubble in the 1980s, this paper analyses why the bursting of the bubble developed into a full‐fledged financial crisis in the late 1990s. In order to cope with this crisis, the Government has injected capital directly into the banking sector and banks have written off enormous amounts of bad loans. However, the Japanese financial sector remains very weak and Japan still faces a number of problems in its financial system. Firstly, the profit margin of banks is too small to cover the increased default risk following the bursting of the bubble, and there are market distortions created by the government‐backed financial institutions and the requirements on new lending to small and medium sized companies. Secondly, banks still have excessive stock investment and crossholding of shares between banks and other companies has weakened the market discipline on entrenched management. Thirdly, the government guarantee of all banking‐sector liabilities should be removed. Once the financial system is stabilised, a risk‐adjusted deposit insurance premium should be introduced so as to strengthen market discipline on banks, and the huge postal saving system should be privatised to create a level‐playing field among deposit taking financial institutions. Besides the foregoing, the weak corporate governance structure of Japanese financial institutions has to be remodelled. The management of banks has shielded themselves by extensive cross‐shareholdings, especially with life insurance companies. There has been extensive mutual provision of capital, most large life insurance companies have weak corporate governance, and many of the large shareholders of banks are life insurance companies. This double gearing between banks and life insurance companies has therefore weakened the market control of Japanese financial institutions.