Structural Disposal and Cyclical Adjustment: Non-performing Loans, Structural Transition, and Regulatory Reform in Japan, 1997-2011

Japan experienced falling asset prices, implemented financial market reforms, and was forced to reduce non-performing loans from the late 1990s to the mid-2000s. As the market reform prompted the corporate sector to replace bank borrowing with bond flotation and hence the banking business shrank, a rapid reduction of non-performing loans required a massive write-off of standing loans. We examine whether it was appropriate for the regulatory authority to guide the banking sector to aggressively write off nonperforming loans in the early 2000s or to wait for cyclical recovery, along with the structural reform. We show that non-performing loans could have been cyclically reduced only by a further extension of mortgage loans, since the deregulated corporate sector scaled back its reliance on banking. Although a further deregulation of mortgage markets might have enable cyclical reduction in non-performing loans, structural non-performing loan disposal is justifiable if another housing market bubble was to be avoided.