[paper] Structural Traps and Global Financial Risk

Robert H. Dugger: Managing Director of Tudor Investment Corporation

He was previously Director for Policy and Chief Economist at the American Bankers Association, Chief Economist of the Senate Banking Committee and Senior Staff Member of the Financial Institutions Sub Committee of the House Banking Committee, and has held a position with the Federal Reserve Board. He is also a founder of the African Capital Markets Committee. Received his Ph. D from the University of North Carolina at Chapel Hill.

Building the Financial System of the 21st Century

To promote economic stability and growth, financial institution policy must respond to changing economic conditions. When I think about financial policy in this regard, I always first ask what is the structural context in which institutions are acting. Are important GDP growth components changing? Are they being affected by changes in government subsidies, tax treatment, market protections, or other policies? Have external conditions changed in any important ways?

For Japan, the answer to these questions is definitely, yes. On this there is little dispute. For the United States the answer is less clear, but I believe more and more careful thinkers are moving to the view that some of my colleagues and I have held for several years. We have argued, only recently with success, that the structure of US GDP is facing significantly changed circumstances, implying that the current economic slowing is far from being a standard business cycle.

In our view Japan is in a "structural trap", and the US could be drawn into one. The indicators of a structural trap include political resistance to restructuring reform, limited capital reallocation, dependence on government spending and guarantees, persistent goods and services price deflation, and currency strength.

In these remarks, I will briefly describe a structural trap and review Japan's banking situation and recommended policy actions. How the Koizumi government deals with its bank non-performing loan problem is a key determinant of whether Japan can escape and recover. But Japan is not my only concern. The deeper Japan is in its structural trap, the greater are the risks to global capital markets.

Structural traps evolve slowly.

When an economy develops for many years within a set of economic incentives -- external conditions and spending, tax, and market policies that promote some economic sectors and constrain others -- the promoted sectors in time become the major contributors to national GDP and reflect the composition of the incentives. Infrastructure building and export-production are examples of promoted sectors in Japan. (Home building and consumer-retail are examples of promoted sectors in the US.) All were multi-decade beneficiaries of an incentive structure consisting of institutional and tax subsidies, market protections, and geopolitical importance.
If the economic incentive structure (external conditions and domestic subsidies and protections) is change and weaken, the economy is vulnerable to slowdown. The previously supported sectors will tend to contract, and all too often, the unsupported sectors will not expand enough to keep GDP rising satisfactorily. This asymmetry causes GDP to weaken and is the initial tilt toward a structural trap.

If political leaders do not understand that the economic slowdown is the result of longer-term structural changes and are not familiar with the effectiveness of private market decision-making, they may attempt to protect to an inappropriate degree the promoted sectors from needed reallocations of capital. They may use government spending and credit guarantees to keep capital committed to the promoted sectors in an effort to protect business and employee constituents from restructuring pain.

If the spending and guarantees serve to "cushion" constituents from unnecessary short-term disruption, but do not prevent needed longer-term reallocations of capital from low return uses to high return ones, the policy actions may enable the country to avoid falling into a structural trap. The litmus test of whether policy actions lead a country into a trap or not is whether the actions facilitate or obstruct capital reallocation.

Trap economics.

The economic indications of a structural trap are: absence of capital reallocation, economic dependence on government spending and guarantees, goods and services price deflation, and currency strength. The structural trap concept highlights the political dimensions of an economy's inability to generate growth. It asks the question: Are the indicators of a trap the results of monetary and fiscal policy failures, or the results of actions by established elected officials attempting to maintain political control of the government?

The economic aspects of a structural trap are understood and increasingly accepted. Harold Cole and Lee Ohanian describe how a monetary shock was turned into a ten-year depression by fiscal policies that obstructed effective capital reallocation. Christina Romer goes so far as to explain the end of the US 1930s depression as resulting from the way World War II forced the US to abandon ineffective fiscal policies. Marvin Goodfriend examines how fiscal policy efforts can become counterproductive in the specific case of zero-interest rates. Bank of Japan Policy Board Member Kazuo Ueda commented on the linkages between fiscal and monetary policy when structural issues are important.

Our monetary policy framework can be combined with a variety of policy options in other areas. For example, it can be combined with serious efforts at structural reforms by the government. Such efforts may produce deflationary forces in the short run, but will generate a much more efficient economy after a while. Even in the short run improvements in confidence due to the announcement of the reform plan may produce favorable impacts. Our framework will go a long way towards supporting such reforms. The maintenance of near zero rates will mitigate possible deflationary forces. Liquidity provided will be put to efficient use as reforms progress.

Of course, the government has other policy options to be combined with our monetary policy. If I were to talk about an extreme, hypothetical example, the fiscal authority might decide to increase expenditures or cut taxes on a very large scale. Possible upward pressures on interest rates will be mostly contained by our commitment of liquidity provision. The policy mix would stop deflationary forces after a certain point. Of course, we will not allow a runaway inflation because our commitment to provide large amounts of liquidity is effective only so long as the rate of inflation is below zero. Thus, what the policy mix would achieve is to affect the time it would take for the economy to end a period of deflation. With this policy mix the time to a positive inflation rate may be shorter than with the previous example. But the structure and the efficiency of the economy at the time we will be able to terminate our commitment will also be different. For example, this mix may end up in preserving the high share of the old economy. The fiscal situation will surely worsen.

Most recently, BOJ Board Member Noboyuki Nakahara stressed that cautious approaches to dealing with bank capital and management weakness need to be overridden and aggressive, politically unpopular actions taken.

A country risks entering a structural trap when its political leaders attempt to avoid needed restructuring by resorting to deficit spending, government credit guarantees, and extreme monetary ease. Without the restructuring which would enable capital to flow from low return uses to high return ones, the economy continues to weaken. Political leaders resort to more spending and guarantees, the economy becomes more dependent, and the government's share of the economy steadily increases.

Month by month, more and more of the economy becomes frozen, and as it does, national income, consumption, investment, and savings decline. Government borrowing (direct and contingent) grows relative to domestic saving. The current account shifts toward the red. Real interest rates rise and the currency strengthens.

Rising volumes of non-performing bank loans (NPLs) and falling stock prices are financial market evidence of deteriorating private sector profitability. The NPLs consist mainly of companies and households in the old supported sectors. Their ability to avoid outright default depends on continued government support, without which the businesses would fail and the banking system would collapse.

Trap politics.

The political incentives that face elected leaders in a restructuring contraction are critical. If economic incentives are successful over a long period of time in achieving good economic growth based on steady expansion of the promoted sectors, the political leadership that designed and implemented the incentives becomes stronger. Relationships among business executives, worker groups, bureaucrats, financial institutions, and political parties developed to frame and execute the incentive policy deepen and shape political activity. The governing political parties come to dominate the political scene year after year.

When economic incentives change and the economy weakens, political leaders have a difficult choice. They can use the tools of macroeconomic policy to ease the capital reallocations necessitated by the incentive changes, or attempt to keep capital allocated to the promoted sectors. Fiscal and monetary policies can cushion the short-term effects of a restructuring economic contraction and provide time for private decision-makers to adjust and for policymakers to implement reforms that facilitate capital reallocation, reduce the depth of the downturn, and quicken the return to growth. When used to preserve control of the government, however, fiscal policy including widening credit guarantees can quickly become an instrument for resisting capital reallocation and new sector development.

In a structural trap it is not irrational for elected officials to resist reforms. By resisting reforms that increase private investment returns, officials can preserve the government's ability to finance itself. Because the guarantees and deficit spending are invariably allocated to old-line promoted sectors and support the banking system, elected officials can also assure themselves of continued political support. The song to voters is always the same -- one more stimulus package and growth will return and this economic pain will stop.

Political incentives are strong to persistently oppose reforms that would enable private investment returns to attract to domestic savers and investors, especially at zero interest rates. Instead, deflation and currency strength provide positive returns on government-backed investments. Goods and services deflation enables household savers to earn a higher real return as a result of their ability to buy more with their savings. Investors who do not benefit from price deflation (because they are not goods and services consumers) are rewarded by a rising currency. Even at zero-interest rates, there is an amount of deflation and currency strengthening that will satisfy savers and investors.

Whether a country is in a structural trap depends on whether the politics of preserving the promoted sectors in the face of changing external and domestic conditions are stronger than those which would allow capital to be reallocated. Persistent deflation combined with currency strength can be initial signals that a country is in a structural trap. If an examination of government policy reveals a steadily expanding reliance on fiscal spending and credit guarantees to prevent the contraction of older promoted sectors, it is almost certain the country is in a structural trap.

Trap end game.

The policy of endlessly increasing government spending and widening government guarantees cannot work forever. Policy exhaustion can take many forms. In a developed economy, finance ministry intervention to stop excessive currency strengthening is a likely sign of exhaustion.
With enough intervention, markets will become convinced that the currency has plateaued. At that point, foreign and domestic investors (those who do not benefit from the steady fall in consumer goods and services prices) will begin to move capital out to capture the higher nominal returns available on foreign investments.

The capital flight will at first be mild, and because it is mostly hedged, the weakening effect on the currency will be small. As markets become more confident in the finance ministry's seriousness, the unhedged flight will grow and as it does, domestic nominal interest rates will rise. And as interest rates rise, businesses that could survive only in a zero-rate environment will fail. Government revenues will decline and interest expenses will rise causing the fiscal situation to deteriorate further. At this point the risk of a destabilizing "sudden stop" will become significant.
Trap victims who fail to escape eventually experience catastrophic restructuring resulting from domestic capital flight, government fiscal failure, sudden currency weakness, rising interest rates, and waves of business failures.

Trap victims pose systemic risks to other countries via sharp changes in current account flows and currency values. Instability increases capital costs globally.

Japan's end game.

We can date Japan's entrapment from roughly 1997. Since that time Japan's nominal GDP has been falling, and real interest rates and the trade-weighted yen have been rising. Reformers have succeeded in instituting many changes beginning with the "Big Bang" financial market reforms in 1998. However, the overall policy situation has been one of successful LDP old-guard resistance to allowing capital to move from low return sectors to high return ones.
Nominal GDP

Until recently, the Japanese government was able to keep domestic savings at home despite near zero interest rates. Its spending and guarantee policies obstructed capital reallocation and resulted in higher and higher real interest rates -- the difference between near-zero nominal rates and a declining price level -- and a strengthening yen.

In the summer of 2000, however, the yen became too strong, and this autumn a policy of containment had to be implemented. The Ministry of Finance intervened seven times in September and October to ensure that the dollar and euro will not fall below 115 dollar/yen and 106 euro/yen.

Affluent families and profitable businesses who did not benefit from price deflation saw an opportunity to invest safely abroad and earn yields 5 or 6 times those available on yen securities of comparable risk. MOF intervention showed them that they need not be afraid that new purchases of dollar and euro investment grade securities will fall in value. Now capital is beginning to flow out of Japan in significant amounts.

Portfolio investment outflows on a contract basis are averaging about 400 billion yen per week -- the 3-month average is Y1.945 trillion per month. This compares to a 3-month average of Y185 billion in the January-March quarter of 2001. Annualized, the current rate is Y23 trillion per year, almost 5% of GDP.

Japan's Banking Problem

The Koizumi government is steering between actively restructuring and doing nothing. Reform announcements keep all options open. The options range from limited reform to banking system nationalization.

The Koizumi government should start assembling an army (kinyuu saisei guntai) to attack the NPL problem. Solving the NPL problem requires a dedicated army of at least a thousand people. Until the Koizumi government starts to assemble this army, investors at home and abroad can take nothing it says about NPLs seriously.

The Koizumi government should move now to deleverage a few debt-burdened companies. Fixing just four companies, for example, selected by each of the major banking groups, will show that reform works. Fixing a few companies now would be a positive for growth and jobs and show what the Japan Deleveraging Fund can do.

The Koizum government should focus on establishing a global distressed asset exchange headquartered in Tokyo. Such a new institution would reduce the NPL costs and make Tokyo the London of Asia.

NPL Problem

There are many ways to measure the NPL problem. Tadashi Nakamae recently provided a quite clear analysis based on defining a borrower in trouble as a company whose net operating earnings are less than its interest expense. Using this definition and analyzing the March-end 2001 financial reports of millions of companies, he found that the size of the non-performing loan (NPL) problem is not less than Y130tr.

Nakamae points out that even after adjusting reserves for write-offs, shareholders’ equity, and land collateral for loans, banks have a capital shortage of at least Y80tr, and potential problem loans will inevitably rise as the recession deepens and/or interest rates rise.

Unrealized capital gains on equity holdings have turned into latent losses. Nakamae explains that with Y5tr in annual net operating profits as the only source for banks to write off bad loans, it will take almost 16 years for them to dispose of the NPLs. Alternatively, settling the NPLs over three years would require a public funds injection of Y66tr.

Nakamae documents that during the past eight years, banks have disposed of Y70tr in bad loans (Y7.8tr per year on average), principally relying on 1) net operating profits of Y38.6tr (4.8tr per year) and 2) realized capital gains on equity holdings of Y19.4tr (2.4tr per year). In addition, there was a Y9.1tr windfall from accounting changes and a Y6.5tr public funds injection. All together, banks’ resources for write-offs amounted to Y73.6tr.

Based on the numbers at the end of March 2001 (ignoring subsequent losses from equity holdings), the total size of NPLs amounts to Y130tr, 90% of which is unrecoverable (Y114tr). Against that, banks hold Y11.6tr in reserves for write-offs. Combined with an estimated Y21.4tr of net shareholders equity, banks hold Y33tr in resources that could be used to write off bad loans. These figures leave nearly Y81tr worth of NPLs uncovered by banks' capital.

To complete NPL disposal within three years, banks could only rely on their Y5tr in annual operating profits (a total of Y15tr). A public funds injection to offset this shortfall would require at least Y66tr (Y81tr -Y15tr) and still additional money to replenish bank capital.

1. The Koizumi government is steering between actively restructuring and doing nothing. Reform announcement keeps all options open. The options range from no reform to banking system nationalization.

Prime Minister Koizumi's leadership is the key determinant of whether Japan can escape its Structural Trap. At the same time he is managing a historic shift in Japanese foreign policy as part of the global anti-terrorism effort, and he is also trying to safely steer banking policy between the reefs of a restructuring implosion and do-nothing paralysis.

From discussions with government officials and market participants, four different policy paths are evident. (1) Stick with current policy and basically resist changing anything. (2) Expand the Resolution and Collection Corporation (RCC) and buy NPLs from failing banks to keep them afloat. (3) Toughen FSA supervision, take over weak banks and re-privatize them via good-bank/bad-bank transactions while deleveraging viable but over-indebted companies. (4) Nationalize the banking system. Nearly everyone agrees that options (1) and (4) should be avoided. They also agree that the most likely course in the near term is (1). The problem many of them emphasize is this: pursuing (1) almost guarantees (4).

Government Reform Statements.

Koizumi government reform announcements continue to keep all options open. The announcements emphasize special inspections of banks in which the FSA will link up with independent auditors to jointly inspect banks beginning 2002 during the January-March and July-September quarters. The FSA will urge banks to revise their loan assessment categories for borrowers suddenly cast in a negative light by the market as reflected in corporate stock and bond prices and private agency debt ratings. If the inspections determine that a borrower is in danger of failing, then presumably its debts will be disposed of immediately.

Statements also call for expanding the RCC's capacity to purchase NPLs from banks and setting up a privately-backed "deleveraging fund" to buy viable company debts and restructure their balance sheets using debt-equity swaps.

Seidman, Gitlin, and Cooke Recommendations.

By continuing to lend to large numbers of small and intermediate sized companies, the banking system is funding a wide economic support and unemployment safety net. As the Nakamae data show, these businesses number over 2 million, employ over 75 % of Japan's workers, and account for over 65% of total sales.

Bill Seidman, the former head of the US RTC, understands this. His advice to the Japanese government is "First do no harm". He has repeatedly stressed that it is crucially important to limit the life of the distressed asset resolution institution (RCC or its alternative), give it full power to hire, fire, and contract with private sector companies, and to begin staffing this institution immediately. He worries that because he sees no work being done to prepare for dealing with NPLs, the government is not really serious about halting NPL deterioration.

David Cooke, drawing on his experience resolving problem loans in the US (as the RTC's chief operating officer) and around the world, advised officials to set up a distressed-asset exchange headquartered in Tokyo. The exchange, he says, will advance Tokyo's financial leadership, get the highest prices for assets and minimize taxpayer costs. His experience indicates distressed assets will go through several stages of restoration and be sold several times as they pass from venture restructurers to final long-term investors and owners. The distressed asset exchange could maximize liquidity and prices at every stage.

Richard Gitlin, the noted deleveraging expert, has long called for using debt-for-equity swap transactions to unburden viable over-indebted Japanese companies. Some top policymakers listened and were successful in including a reference to establishing a privately-backed deleveraging fund in Koizumi's September 21, 2001 statement. The fund would acquire viable company loans and move them out from under crippling debt burdens by converting loan debt into equity ownership, fixing the companies by spinning off non-core activities, and making them profitable again. The focus of his advice is on increasing economic and job growth through deleveraging viable companies, one company at a time, and to begin doing this now.

Four Bank Policy Options.

Drawing on the comments of scores of private and public officials, the Koizumi government's bank policy options consist of basically four paths.

(1) Implement only marginal reforms, stick with the current go-slow policy, and play for time. Importantly, both anti-reformers and radical restructuring advocates support this option. This option would seem to be unthinkable, but many informed people believe it far and away the most likely outcome for the foreseeable future.

Anti-reformers obviously support this option. They see Japan as different from the US and other countries in ways that make the reform options on the table unacceptable.

Some radical restructuring advocates support this option because they do not believe the kind of restructuring Japan needs can be guided by the government. Instead, they argue Japan needs a market-driven reform process, and the only way to get that process is for the government's efforts to totally fail. These observers believe that a crisis that discredits mainstream political leadership is the only way to jumpstart change. For them, the 1990 reforms separating bank supervision from the Ministry of Finance and establishing the FSA and RCC were merely window-dressing. They allege that the bureaucrat old-boys willingly wrote into law what the reformers wanted, knowing that all along the names above the door might change, but the policies would not.

(2) Expand the Resolution and Collection Corporation (RCC) and buy NPLs from failing banks to keep the banks afloat. Though details vary, this option involves using the organization framework shown above without a deadline on the RCC for disposing of NPL assets. The FSA and MOF would arrange to expand RCC funding from the market and/or the BOJ. The RCC would then buy non-performing loans from banks at "flexible" prices.

The meaning of "flexible" is a political battleground, obviously. The Koizumi government has said NPLs should be bought at market prices rather than book value. Some FSA officials interpreted the Prime Minister's statement as intending to ensure that "there is no additional public burden". The difference between these two interpretations is night and day. Market prices, even in a very liquid fully transparent market, would almost certainly mean additional public funding for the banking system.

LDP Diet members say they want to avoid detailed discussions as much as possible and authorize the RCC to buy NPLs at somewhere between book value less reserves and the no-loss low level the RCC now pays. The price could include provisions for the RCC and banks to share in future losses (and gains).

Opposition party leaders want to open the pricing issue fully to clarify the amount of taxpayer money, if any, this option provide to weak banks.

(3) Toughen FSA supervision, take over weak banks and re-privatize them using standard bank resolution techniques. This option involves implementing the September 21, 2001 statement with an emphasis on toughening the FSA and using stock and bond prices to determine loan classifications. The additional loan loss reserving would reduce bank capital positions, and the FSA would initiate prompt-corrective-action supervisory actions. If banks cannot improve their operations or meet the reserving requirements dictated by stock and bond-price default probability models, they would be taken over by the government.

These banks would be resolved using standard techniques such as good-bank/bad-bank transactions in which new "good banks" are created with no NPLs and are re-privatized by selling the stock to investors within a fixed, short time period. The new investor/owners would decide what to do with the old management. The bad-banks would be managed by a new government entity (similar to the US RTC) and liquidate it over a limited time period of, say, three years.

An important and attractive aspect of the weak-bank takeover option to politicians, is the fact that it eliminates the troublesome NPL price issue. In this option, there is no immediately evident final price. The government gets ownership of the NPLs when it takes over a bank. The actual cost of most of the NPLs would not be clear for several years even in a quick resolution process.

In conjunction with weak-bank takeovers, a "deleveraging fund" could be established to buy debts of viable companies from the bad-bank liquidators. The deleveraging fund would restructure company balance sheets using debt-for-equity transactions that leave the company relatively debt-free and competitively profitable.

(4) Nationalize the banking system. A surprising number of people involved in bank policy-making advocate nationalizing the banking system. For them, the present uncertainties are unacceptably high and slowing the economy. They see the banking system as being effectively nationalized already. Liabilities are 100% guaranteed by the government explicitly in the form of deposit insurance and implicitly under a policy in which virtually every bank is "too-big-to-fail".
Nationalization, they argue, would enable the government to (a) Takeover and stabilize the banking system. (b) Separate bad loans from good ones and dispose of them over a "realistic timeframe". (c) Consolidate the banking industry in a rational way. (d) Re-privatize banks on a sound competitive basis. (e) Eliminate the risks that now permeate a system that could see forced disruptive business failures at any moment.

Bank failures or government takeovers can be triggered by many factors. The most likely is an inability to pay dividends on government preferred stock capital infusions. If a bank cannot pay the contracted dividend, the preferred stock converts to a majority amount of common stock and the bank becomes government controlled.

Other systemic nationalization risks include (a) Refusals to roll over existing debt by one or more banks triggering thousands of cross defaults. (b) A withdrawal by Fuji Bank from its agreement to merge with profoundly weak DKB and IBJ banks. (c) A rise in the overall rate of corporate bankruptcies. (d) A large, sudden and catastrophic corporate failure. There are obviously significant linkages between these possibilities and very large yen and JGB market declines.
2. The Koizumi government should start assembling an army (kinyuu saisei guntai) to attack the NPL problem. Solving the NPL problem requires a dedicated army of at least a thousand people. Until the Koizumi government starts to assemble this army, investors at home and abroad can take nothing it says about NPLs seriously.

The key distinction between the policy scenarios outlined earlier is the role of the RCC or its substitute. If it operates rigorously, that is within a fixed deadline, with adequate resources and a mandate to actively and transparently process distressed assets back into the private sector, the banking problem can be solved. If not, it can't.

David Cooke estimates that no less than a thousand people will be needed to enable the RCC to operate rigorously. David should know. He was the chief operating officer of the US RTC and has set up distressed-asset disposal companies in fourteen countries around the world.

The Koizumi government needs to present a plan and a budget for rigorous distressed asset disposal. Someone should call David Cooke + 1 (703) 747-7560.

Until Koizumi starts assembling an army to attack the NPL problem, market participants will take nothing he says about NPLs seriously. The most disappointing aspect of current Tokyo NPL discussions is this: there is no evidence yet that anyone is starting to assemble the army needed to attack the NPL problem. Bill Seidman noted this repeatedly in meetings in Tokyo last September. Since then, discussions with market participants indicate to us that this judgment is more and more widely and deeply held.

Whether it's the RCC or some other institution, success in dealing with the NPL problem will initially require at least 1000 people with a variety of key professional and support skills. These people need to be identified and preparations need to be made to bring them into an effective organization. Even if officials start today, it will take up to a year for this new organization to begin its critically important work. By not beginning, officials are signaling that they have no intention of disposing of problem loans for another year or more.

Investor capital will continue to flow out of Japan until it is evident political leaders are starting to assemble the army of professionals needed to process NPL assets back into the private sector.
There are two kinds of banking system nationalization -- bad and good. Earlier I outlined four bank policy choices. The fourth is de jure nationalization. If it occurs without a rigorous exit plan, the result will be expanded economic paralysis and a government deficit crisis -- the end game of a Structural Trap. If it occurs with a rigorous exit plan that allows capital to move from low return uses to high return ones, it is possible to solve the banking problem, avoid a government funding crisis, and escape the trap.

Good nationalization consists of rigorous standards and deadlines. For banking system nationalization to succeed, things listed below have to happen. Every successful bank resolution process in the past 50 years has had these characteristics.

(1) Full responsibility: The government must take full responsibility for the banking problem and create an overarching agency with supreme authority to deal with weak banks and NPLs.
(2) Time Limits: Firm deadlines must be established --
(a) Re-privatize nationalized banks by selling them back to the private sector
(b) Close down the NPL asset management company and transfer all profits or losses to the government
(c) Bring corporate debt-equity ratios down to international levels
(d) Bring financial sector supervision up to global standards
(e) Remove the government's blanket guarantees of bank liabilities
(3) Implementation: The government must enact laws that --
(a) Provide a blanket guarantee of all bank liabilities to ensure confidence in the system during restructuring
(b) Establish an NPL distressed-asset disposition agency or asset management company which has clearly adequate human, legal, financial, and marketing resources and powers
(c) Ensure quick, effective bankruptcy processing
(d) Direct the bank supervision agency to identify and resolve weak or insolvent institutions
* Non-viable banks are taken over and liquidated, merged, or bridged. Bad assets are transferred to the asset management company.
* Viable banks are recapitalized, rehabilitation plan is implemented, and bad assets are transferred to asset management company. The stakes of existing shareholders are diluted.
* All banks should undertake corporate workouts (London approach) in the context of bank rehabilitation plans. Corporate debt equity ratios should be reduced.
(e) Improve financial institution regulation and supervision
*Accounting practices must result in transparency
*Financial institutions must be accountable to stockholders
* Supervisory agencies must have a full range authorities and mandates to use them
* Prompt corrective action
* Basle Core Principles 3. The Koizumi government should move now to deleverage a few debt-burdened companies. Fixing just four companies, for example, selected by each of the major banking groups, will show that reform works. Fixing a few companies now would be a positive for growth and jobs and show what the Japan Deleveraging Fund can do.

One of the most exciting and positive elements of Koizumi's September 21, 2001 reform plan was the Japan Deleveraging Fund (JDF). The purpose of the JDF is to fix good but troubled companies in Japan before they become too sick to revitalize. The JDF will fix companies by doing-debt-for-equity swap and other transactions that reduce a company's debt burden and make it competitive again. The JDF will strengthen businesses and balance sheets, and add to growth and jobs.

Fixing four companies, selected by each of the major banking groups, will show that reform works. Richard Gitlin stresses that it is advisable to fix the good but troubled companies while keeping the loans in the bank. This is because:

1. When the restructuring is completed, the banks will maintain the relationship with the deleveraged company. The bank will then have a strong customer rather than a weak one. The company will not have to find new banking relationships to finance growth and employment. This is a win-win story for banks, businesses, and the economy.
2. The bankers who participate in the restructuring with the management team of the JDF will develop advanced credit skills; and
3. The troublesome issue of establishing a price for transfer of the loans to the RCC will be avoided.

Often banks have developed extremely close relationships with management of their borrowers, possibly even sending bank personnel to assist in management. The JDF team could assist in the difficult task of facilitating early restructuring negotiations between the company and the bank.

Concerns about unemployment and foreign "vulture funds" are addressed by this proposal. Some policymakers are fearful that restructuring will:

1. Cause unemployment;
2. Cause disproportionate opportunities for non-Japanese institutions to acquire Japanese assets at low prices; and
3. Not succeed in fixing companies and simply perpetuate sick companies.
Gitlin points out that:
1. The JDF would only pick companies to restructure, that once fixed, would add to long term growth and employment in Japan.
2. The investors in the JDF would mainly be Japanese institutions.
3. Many companies in Japan can be fixed and become engines of long-term growth and employment, but failure to act now may cause them to become too sick to be fixed.
4. Foreign "vulture funds" make the most money when policymakers do not take actions on their own to fix its viable debt-burdened companies. Vulture funds take advantage of illiquidity, non-transparency, and crisis.

The Japan Deleveraging Fund was part of the September 21 reform plan. The JDF is not expected to be operational before March 2002. Gitlin points out that the best way to demonstrate the value of the JDF is to actually fix a few Japanese companies now. Getting a few of them out from under debt burdens and growing again would affirm the reform goals of the government and add to credibility.

Gitlin stresses that a "mini JDF" needs be organized as soon as possible. The mini JDF would work with the four major banking groups in Japan to pick one candidate company for restructuring from each group.

The mini JDF would be managed by a professional team with both Japanese and global experience. It is hoped that the Development Bank of Japan would be both a facilitator of the creation of the JDF and a minority investor in it, and one or two additional Japanese private financial institutions would be additional investors in the JDF.

Fixing a few companies now would be positive for growth and jobs, and show what the Japan Deleveraging Fund can do. Although ambitious, the goal would be to reach agreement on restructuring plans for all four companies by March 2002. The marketplace will have much more confidence in the viability of the program if proven examples were disclosed at the same time as the commencement of the program is announced.

In essence, the recommendation is that Japan takes action now to prove that there is a Japanese solution to fix troubled companies.4. The Koizum government should focus on establishing a global distressed asset exchange headquartered in Tokyo. Such a new institution would reduce the NPL costs and make Tokyo the London of Asia.

People and technology are the keys to getting the highest prices for Japan's distressed assets. Success will add to Japan's financial service leadership and minimize taxpayer costs. A computer-based distressed asset exchange located in Tokyo will enable NPLs to be sold at highest prices to bidders from around the world. The exchange will make Tokyo the world leader in this financial activity. See David Cooke about how to do this.

To fully dispose of the NPL problem, the RCC will probably need 5 to 10 thousand employees and contract with 50 to 100 thousand private sector people. Tens of thousands of people will need upgraded legal, accounting and business management skills to manage the assets. The national retraining program will help deal with rising unemployment.
Here is what needs to be done.

A. Beginning now, build a computer-based distressed asset exchange. For details on this, see David Cooke. The internet exchange should enable investors to --

(1) See what assets are for sale.
(2) Obtain a complete and accurate description.
(3) Get quick, accurate answers to questions about the assets.
(4) Participate in auctions for the assets involving buyers from all over the world.
(5) Complete the purchase and obtain title to the asset.

B. To successfully sell assets on the exchange, the selling entity (a bank, the RCC, the government, etc) needs to make sure --

(1) The needs of buyers must be researched and thoroughly understood.
(2) Assets should be reshaped to meet buyer needs.
(3) Information about assets should be available to all potential buyers globally at the same time.
(4) The description of the asset must be complete -- no hidden liabilities.
(5) Authoritative answers to buyer questions should be quickly available.
(6) Initiate a nation-wide program to train tens of thousands of younger and older people in modern legal, accounting, and business management skills.