Are the Major Japanese Banks Uniform or Unique?

Transcription

1 Are he Major Japanese Banks Uniform or Unique? Kahryn L. Dewener* Universiy of Washingon Yasushi Hamao Universiy of Souhern California Alan C. Hess Universiy of Washingon July 2004 Absrac We use banking heory o ry o undersand he loan loss provisioning and wrie-off behavior of Japanese banks during Japan s economic slow growh period ha began in We compare Japanese ciy and rus banks, and Japanese banks wih banks from oher counries ha have similar banking sysems. A major and surprising finding is ha Japanese ciy banks differ from Japanese rus banks, bu no from banks in oher counries wih similar banking sysems. The Japanese banks are neiher uniform nor unique. JEL: G21, G28, G33 Key Words: Loan loss provisions, wrie-offs, relaionship or universal banks, Japan *Auhors can be conaced a [email protected] (for Dewener), [email protected] (for Hamao), or [email protected] (for Hess). We hank Akira Mizofuchi of Nomura Securiies for discussions and providing some of he daa.

2 Are he major Japanese banks uniform or unique? Absrac We use banking heory o ry o undersand he loan loss provisioning and wrie-off behavior of Japanese banks during Japan s economic slow growh period ha began in We compare Japanese ciy and rus banks, and Japanese banks wih banks from oher counries ha have similar banking sysems. A major and surprising finding is ha Japanese ciy banks differ from Japanese rus banks, bu no from banks in oher counries wih similar banking sysems. The Japanese banks are neiher uniform nor unique. I. Moivaion Kashyap (2002) repors ha while he Japanese public and regulaors may no admi i, he major Japanese banks as a group are bankrup. 1 He claims ha he bad loans of major banks exceed heir capial. 2 This may no be readily apparen because Japanese banks underrepor heir non-performing loans and hey under reserve for heir acknowledged bad loans. According o Hoshi and Kashyap (1999) he reurn on asses of Japanese ciy banks declined from 1955 hrough 1997, and he decline increased in he 1990s. Smih (2003) shows ha he increased decline is due o increased bad loans. He decomposes Japanese banks profis ino core earnings; ne gains on securiy holdings and sales; and loan loss expenses from provisions and direc wrie-offs. Core earnings were relaively consan over he years 1982 hrough 2001 and gains on securiies flucuaed beween posiive and negaive while averaging abou zero. From 1982 hrough 1 Since he major banks had and coninue o have posiive sock prices Kashyap s commen refers o heir book values no heir marke values, which include he value of inangible asses. 2 Kashyap (2002) bases his conclusion on capial and loan loss esimaes prepared in 2001 and 2002 by analyss from Goldman Sachs, Morgan Sanley, ING Securiies, Credi Suisse Firs Boson, Lehman Brohers and Fich Raings. Their esimaes of ne loan losses in 2002 for he major banks average 21 rillion. This is similar o an official esimae of non-performing loans a major banks in 2002 of 20 rillion. See Figure in Annual Repor on he Japanese Economy and Public Finance 2003, Ocober 2003, Cabine Office, Governmen of Japan. hp://www5.cao.go.jp/keizai/index-e.hml 1

3 1990 loan losses were relaively small and banks had posiive profis. Beginning in 1991 loan losses increased and cumulaive bank profis were negaive from 1995 hrough The poor performance of Japanese banks is also refleced in comparisons wih oher banks around he world. 42 of he 250 larges banks in he world according o 1998 oal asses in BankScope s daa se are Japanese. Among hese banks, he average raio of impaired loans/gross loans is 6.72 for he Japanese banks and 4.52 for all of he ohers. ROA is 0.73% for he Japanese banks, 0.47 for he ohers. In The Banker s July 2000 lis of he 1000 larges banks in he world, 18 of he 100 larges banks in he world ranked by asses are Japanese. However, here are no Japanese banks among he 100 mos profiable measured in erms of reurn on asses, and 26 of he approximaely 150 banks wih NPL/Loans above 5.00% are Japanese. Smih (2003), Hoshi and Kashyap (1999), Hayashi and Presco (2002), and Barseghyan (2003) provide explanaions for he poor performance which include a weak economy, lax or delayed regulaory inervenion, and managemen incenives. All of hese explanaions rea he Japanese banks uniformly. This makes sense wih respec o he economy, bu he banks could differ wih respec regulaory reamen or incenives. In his paper we use banking heory o ry o undersand he loan loss provisioning and wrie-off behavior of Japanese banks during Japan s economic slow growh period ha began in We focus on loan loss provisions and wrie-offs because much of 3 Official governmen daa show ha major banks disposals of non-performing loans also exceeded heir core operaing profi in See Figure in Annual Repor on he Japanese Economy and Public Finance 2003, Ocober 2003, Cabine Office, Governmen of Japan. hp://www5.cao.go.jp/keizai/indexe.hml 4 Japanese GDP grew 3.8% per year from , and 1.1% per year from Source: Cabine Office, Governmen of Japan hp:// 2

4 he discussion of he banks problems ceners on he supposedly abysmal qualiy of heir loan porfolios. How he banks choose o provision for and wrie off heir problem loans are criical decisions. We wan o know if he major Japanese banks are uniform or unique relaive o each oher and o banks in oher counries. We begin wih a heory ha reas loan loss reserves as an invenory, wih provisions coming in and wrie-offs going ou. This heory gives us an empirical model for boh loan loss provisions and wrie-offs. We hen use he model o compare behavior across Japanese banks, and beween Japanese banks and banks from oher counries around he world ha have similar banking sysems. We explore wheher any apparen differences are driven by behavior (refleced in differen model coefficien esimaes) or by shocks (refleced in differen values of he explanaory variables). A major and surprising finding is ha Japanese ciy banks differ from Japanese rus banks bu no from banks in oher counries wih similar banking sysems. The Japanese banks are neiher uniform nor unique. The paper proceeds as follows. In secion II we develop our loan loss reserve invenory model. In secion III we discuss how he economy, regulaory inervenion, and incenives migh affec esimaes of he model. In secion IV we inroduce he daa. Secion V covers he cross secional Japanese bank ess while Secion VI covers he ess ha compare Japanese banks wih banks from oher similar counries. Secion VII discusses possible inerpreaions of he resuls, and Secion VIII concludes. 3

5 II. Invenory model of loan loss reserves In his secion, we build a model of loan loss reserves and hen discuss he facors ha migh aler he way bank managers implemen he model. Dewener and Hess (2003) presen a full discussion of he model. Since banks lend o borrowers whose cash flows may be paricularly difficul o esimae, banks earnings may be opaque o ouside invesors. As such, invesors may demand a premium for he addiional risk of owning a bank s sock. Banks may be able o reduce his premium by signaling heir inside informaion abou he qualiy of heir asses. Two signals for marking-o-marke he bank s asses are he declaraion of nonperforming loans and adjusmens o loan loss reserves. Loan loss reserves, a conra-asse accoun on a bank s balance shee, are an invenory ha has loan loss provisions, an income saemen expense, as an inflow and loan wrie-offs as an ouflow. 5 An incorrec level of loan loss reserves (i.e., an uninformaive signal), on eiher he high or low end, may cause he bank o pay an addiional risk premium o invesors. Invenory heory disinguishes beween fixed-order-quaniy models and fixedreorder-inerval models. In a fixed-reorder-inerval model he invenory manager reorders invenory on a fixed ime schedule. This corresponds o he financial reporing pracices of banks, which have monhly, quarerly and annual reporing schedules. The fixed-reorder-inerval invenory model relaes he cos-minimizing order quaniy o 5 U.S. bank regulaors require banks o follow generally acceped accouning principles (GAAP) and supervisory guidance in deermining heir loan-loss allowances. GAAP include Financial Accouning Sandards No. 114 (FAS 114) and FAS 5. FAS 114 relaes o specific loans ha are non-performing, and FAS 5 specifies allowances for groups of similar loans based on hisorical wrie-offs for loans in he group. See Policy Saemen on Allowance for Loan and Lease Losses Mehodologies and Documenaion for Banks and Savings Insiuions, Federal Financial Insiuions Examinaion Council, July 2,

6 expeced demand, he ime beween orders, he uncerainy of demand, and he beginning invenory. Applying he model o banks, loan loss provisions, LLP, should increase wih he expeced value of loan wrie-offs (normalized by he amoun of loans) over he coming inerval of ime, E ( WO + 1 L ), and wih he probabiliy, zwo σ ( WO + 1 L ) will no have sufficien reserves o absorb unexpeced random variaion in wrie-offs, i during he reorder inerval. 6 The erm z WO is he number of sandard deviaions he bank chooses o se is probabiliy of no having o make unexpeced loan loss provisions. Loan loss provisions should decrease wih he beginning balance of loan loss reserves, LLR L 1 1. The fixed-reorder-inerval invenory model is: LLP L WO = E L z WO WO σ. (1) L L 1 LLR Several of he variables ha deermine loan loss provisions in he invenory model may no be direcly observable or measurable even by a bank s managers. A bank can examine is loans individually and deermine which ones are non-performing, or i can apply hisorical loan losses o a group of loans o esimae a probable amoun of loan losses. Expeced wrie-offs for individual loans ha are non-performing may be relaed o he amoun of is non-performing loans, NPL, which some banks repor in noes o heir financial saemens. Expeced wrie-offs for groups of loans may be relaed o he bank s pas record of wrie-offs and o he book value of is ousanding loans o asses, L/A. WO + = NPL WO L E 1 G,, (2) L L L A 6 The invenory model differs from he model of Laeven and Majnoni (2001). They relae loan loss reserves o expeced loan losses and use he bank s capial o absorb unexpeced loan losses. The invenory model uses loan loss reserves o cover boh expeced and unexpeced loan losses. 5

7 Saing hese wo equaions in a regression forma, gives a wo-equaion sysem ha explains loan loss provisions and expeced wrie-offs. Our daa have an observaion period of one year, during which a bank s managers obain updaes on cusomers loan repaymens. Thus, expeced wrie offs wihin a year may be closely linked o acual wrie offs during he year. LLP L WO WO LLR = β + β + β σ L β L 3 L ε (3) WO L NPL Loans = β 4 + β5 + + u L β6 A (4) Assuming ha bank managers ac o maximize he bank s value wihin he consrains of regulaory guidelines, we believe ha over he long run managers will se loan loss allowances equal o he expeced value of fuure loan losses in accordance wih he invenory model. 7 However, regulaory, macroeconomic, and accouning consideraions may be imporan in he shor run. As specified by he Basel Accord (1988), mos indusrialized naions require banks o mee a minimum raio of capial-o-asses. Under his sysem, he cos o a bank of oo lile loan loss reserves is he chance of losing is charer. 8 Wih insufficien reserves, a bank mus mach a loan wrie off wih an equal charge agains earnings. If is capial raio is low, he direc wrie off of loans could cause he bank s capial raio o fall below he regulaory minimum leading o a loss of he bank s charer. The cos of 7 Wall and Koch (2000) idenify hree differen approaches o loan loss accouning. Economiss say he loan loss allowance should be he expeced value of fuure loan losses. Conrary o he economis s view, he Financial Accouning Sandards Board (FASB) does no permi allowances o reflec he expeced effecs of fuure evens, bu insead requires hem o reflec losses ha are sure o occur due o evens his period. Banking regulaors in he Unied Saes, on he oher hand, view loan loss allowances as a reserve ha is buil up in good imes o absorb losses during bad imes. 8 Since loan loss reserves are pre-ax, a poenial addiional cos of oo lile loan loss reserves is foregone ax savings. 6

8 holding oo much loan loss reserves is he reduced earnings ha could have gone o build up he capial raio, allowing he bank o expand is asses or heir risk. The business cycle may modify how banks apply he invenory model o loan loss reserves. Invenory models assume ha he invenory manager always has funds available o purchase goods for invenory a each reorder poin. In conras, a bank may have insufficien earnings o fund is loan loss provisions and mee is capial requiremens. As Cavallo and Majnoni (2002) repor, if a bank s borrowers operae in an economy subjec o business expansions and recessions, he bank s non-performing loans and expeced loan wrie-offs are likely o increase in recessions, jus when he bank s abiliy o provision ou of income is consrained. The fixed-inerval invenory model can incorporae his uncerainy by having he bank manage is loan loss reserves over a business cycle insead of over a calendar year. Opimal reserves and provisioning increase wih average loan wrie-offs over he cycle, he uncerainy of loan wrie-offs, and he probabiliy ha he bank will no run shor of reserves during he replenishmen period. The probabiliy depends on z PPI, he number of sandard deviaions he bank chooses o guard agains an income shorfall when i has o replenish is loan loss reserves, and σ ( PPI L ) c c, he sandard deviaion of he raio of he bank s pre-provision income o loans. Pre-provision income is income available for loan loss provisions, or income before provisions, axes, and exraordinary iems. The business cycle, fixed-reorder-inerval invenory model is: 9 LLP L c c WO = E Lc c + z WO WO PPI LLR c c 1 σ + z PPI σ (5) Lc Lc L 1 9 The subscrip c means he variable is measured over a business cycle. 7

9 A hird facor ha may affec how managers apply he model is heir capial raio. When he bank s expeced wrie-offs exceed loan loss reserves plus earnings, he bank manager mus choose beween declaring he loans as non-performing, wriing hem off agains capial and possibly falling below he minimum level of required capial, or no recognizing he loans as non-performing and having heir sock price fall if invesors are noisily aware of he undersaemen. 10 Peek and Rosengren (2003) argue ha banks wih insufficien reserves and earnings o absorb heir non-performing loans resor o renewing loans ha have negaive values. They call his evergreening loans. A bank evergreens a loan when i makes a new loan o a disressed borrower and he borrower uses he money o make paymens on is non-performing loan. To mainain is charer, an evergreening bank will firs allocae income o keeping he capial raio a or above is minimum required level. Once he capial raio mees or exceeds is required level, he bank s managers can increase loan loss provisions in response o addiional earnings, all he while mainaining he minimum capial raio. Thus, in he neighborhood of he required capial raio, higher levels of preprovision income (PPI) are associaed wih higher levels of provisions. LLP L PPI = γ 0 + γ 1 (6) L When a bank is no capial raio consrained i can follow he invenory model. 10 Bank loans require borrowers o repay principal and ineres according o a schedule of paymen daes and amouns. When borrowers do no repay heir loans according o he schedule, banks may declare he loans o be non-performing. While here is no universal definiion of non-performing loans across counries, Coravarria e al (2000) repor ha in mos G-10 counries, loans are considered non-performing if (a) principal or ineres is due and unpaid for 90 days or more; or (b) ineres paymens equal o 90-day ineres or more have been capialized, refinanced, or rolled over. 8

10 III. Impac of he economy, regulaory inervenion, and incenives This secion reviews how he economy, regulaory inervenion, and incenives could affec he daa and concludes wih a discussion of he consrains on disenangling he hree effecs. We focus on how he recen evens in Japan migh affec model esimaes. III.A. The economy One effec of he decade-long recession in Japan is he qualiy of banks loans. A weak and worsening loan porfolio should be associaed wih higher levels of boh provisions and wrie offs. Relaively higher non-performing loans, loan loss provisions, and wrie-offs should show up in comparisons of Japanese banks wih banks from oher counries, raher han in he cross secion of Japanese banks (because hey were all subjec o he same poor economic condiions). The prolonged recession may also affec a bank s capial adequacy. Numerous years of low income coupled wih high provisions will decrease he capial raio and hus inroduce an incenive for banks o evergreen poorly performing loans while he bank ries o increase is capial raio. In he model, his manifess iself in a significan posiive relaion beween loan loss provisions and pre-provision income for he banks wih he lowes capial raios. Across he Japanese banks, his could show up in a posiive relaion beween wrie-offs and pre-provision income. This relaion is due o he Japanese bank pracice of direcly wriing off some of heir non-performing loans agains income. (See a full descripion of Japanese bank wrie off mehods in he Daa secion below.) 9

11 III.B. Regulaory inervenion Fearful ha he banks would have a shorage of capial and a banking crisis would be unavoidable, he Japanese governmen ook several measures o increase banks capial during he sample period ( ). In March 1998, he governmen injeced a oal of 1.8 rillion yen ino 18 ciy and rus banks and 3 regional banks in he form of subordinaed deb. However, his urned ou o be insufficien and in March ciy and rus banks and 17 regional banks received a second round of capial infusion oaling 8.8 rillion yen. 11 Effecive March 1999, he governmen also made wo changes in he accouning rules for banks. Firs, banks were allowed o add laen capial gains on heir land holdings o heir capial. Second, banks were allowed o add esimaed ax refunds o heir capial. 12 All hree acions lifed he banks capial raios, allowing or perhaps even forcing hem o inerrup heir ongoing operaions o boos emporarily heir provisions for and wrie-offs of poorly performing loans. As a resul, across he Japanese banks, we expec o find discree jumps in loan loss provisions and wrie-offs in he years during or immediaely following regulaory inervenion. Depending on he amoun of aid received, hese jumps could vary across he banks Capial injecion is based on Financial Funcion Sabilizaion Law (1998), and he 1999 injecion is based on he Early Srenghening Law (1999). Boh are described a hp:// There have been oher occasions of capial infusions o ulimaely failed banks, bu hey occurred afer our sample period. 12 Capial gains from land holdings is based on he Land Revaluaion Law (1998). The esimaed ax refund is based on opinion issued by Japan Insiue of Cerified Public Accounans (May 12, 1998), and confirmed by Minisry of Finance and Minisry of Jusice on June 16, Source: Zenkoku Ginkou Zaimu Shohyo Bunseki. The ax refund may be realized once he loan loss reserve (which is no ax deducible a he ime of provisioning) is acually wrien off and he loss is realized. 10

12 We mus also consider regulaory inervenion in he oher counries we sudy (Denmark, France, Germany, Spain, and Sweden). Of hese counries, Sweden and France boh had banking crises in he early 1990s, bu he crises were over by he beginning of our sample period and banks ha were subjec o he mos severe regulaory inerference are no included in our sample. 13 Wihou comparable inervenions in he oher counries, and assuming he effec of he Japanese inervenions was o boos provisions and wrie-offs, we expec o find relaively higher loan loss provisions and wrie-offs a he Japanese banks han a he banks from he oher counries in our sample. The Japanese bank capial raios could be higher or lower depending on how rapidly he aid was used o clean up heir loan porfolios. III.C. Incenives and conflics of ineres Across banks, he incenives o monior and renegoiae deb vary. These differences will affec he level and ime series behavior of loan loss provisions and wrie-offs. Below we discuss he heory and is behavioral implicaions for our model. III.C.i. Theory Allen and Gale (1995) disinguish beween ransacional and relaionship banks. Relaionship banks, such as he German Hausbanks, he Japanese main banks, and banks in some oher counries provide boh deb and equiy financing o heir cliens, have longlasing ies wih hem, serve on heir boards of direcors and in some cases serve as senior 13 The one excepion o his is a bank in France ha was naionalized, Credi Lyonnais. We conduc robusness ess o confirm his experience does no affec he resuls. 11

13 managers, and renegoiae deb conracs during periods of financial sress. 14 Transacional banks in he former English colonies primarily provide shor-erm bank loans bu no equiy financing, monior loan covenans, have limied inerference in corporae managemen, and are relucan for legal reasons o renegoiae loans of disressed firms. The implici and explici equiy holdings of he relaionship banks in heir cliens lead o conflics of ineres in heir loan monioring aciviies. In his review of banking heory, Boo (2000) idenifies wo characerisics of a relaionship-based financial inermediary: i obains and safeguards proprieary informaion abou each cusomer s business; and i has muliple ineracions wih each cusomer. The close ineracions beween a borrower and a relaionship lender may lead he lender o forbear enforcing loan erms when a borrower is in financial difficuly. Boo calls his he sof-budge problem. The sof-budge problem occurs when he gain o he lender from no enforcing he erms of a loan exceeds is gain from enforcing he loan erms. An equiy claim on he cusomer exacerbaes he sof-budge problem and a senior deb claim reduces i. Dewaripon and Tirole (1994) wrie ha deb exiss o creae a ough invesor who disciplines managemen in hard imes. They show ha sof claimholders (equiy holders) should conrol a borrower s asses when he borrower s financial performance is saisfacory and ough claimholders (deb holders) should conrol he asses when performance is unsaisfacory. Thus, a bank wih an implici or 14 Allen and Gale (1995), Aoki (1994), Aoki, Parick and Sheard (1994), Hoshi, Kashyap, and Scharfsein (1990), Prowse (1996), Seinherr and Huveneers (1994). 12

14 explici equiy sake in a borrower is less likely, ceeris paribus, o enforce a hard budge consrain. 15 Insead, he bank has an incenive o evergreen a problem loan. 16 III.C.ii. Behavioral implicaions Differences in behavior across relaionship banks could be driven by differences in he inensiy of heir incenive o evergreen loans or in heir abiliy o evergreen. 17 We propose several proxies for a bank s incenive o evergreen. The firs proxy, he raio of equiy invesmens o oal asses, indicaes he value o he bank of is opion o wai for he borrower s financial performance o improve. A higher raio indicaes a sronger incenive o evergreen loans. Two addiional proxies consider revenue sources. The raio of fees-o-loan ineres income and he raio of ne fees-o-oal loans measure he breadh of he relaionship wih clien firms and he profiabiliy of non-loan business, respecively. Due o cross-counry differences in he level of deail of income saemens, hese wo measures are no direcly comparable across counries, bu hey are sill informaive for wihin-counry comparisons. Increases in hese measures are associaed wih sronger incenives o evergreen loans. The final proxy is he Tier 1 capial raio For example, an implici equiy claim is demonsraed in Wilner s (2000) rade credior model where a credior wih an enduring, profiable relaionship wih a borrower (bu no an equiy invesmen) grans more concessions o a disressed borrower han would a compeiive lender 16 Berlin e al (1996) show ha a borrower whose business depends on he rus of is suppliers ges beer erms of rade when an ouside agency, such as a bank wih inside informaion, signals ha he borrower is solven. By relying on he lending bank s alleged superior informaion, ouside crediors lend o he bank s borrowers a raes ha reflec he bank s informaion. Ouside crediors will gran superior erms and raes only if hey rus he bank o ac prudenly in is dealings wih he borrowers. To minimize is overall borrowing coss, a borrower will seek ou a bank ha he borrower s oher crediors rus and hink is compeen. Such a bank is one ha renegoiaes lending erms for borrowers ha are in financial disress bu have coninuaion values ha exceed foreclosure values, and o foreclose oherwise. 17 The close ineracions beween lender and borrower may give he relaionship bank superior informaion. However, Dewener and Hess (2003) show ha among relaionship banks ouside Japan, he incenive effecs seem o overshadow he informaion effecs. 18 Tier 1 capial, someimes called core capial, is a risk-weighed measure of capial adequacy where equiy and disclosed reserves are couned as capial. Tier 2 capial includes oher iems such as undisclosed 13

15 As noed above, a capial consrained bank has an incenive o coninue evergreening loans as i uses is income o increase is capial raio. If a bank evergreens a loan, he borrower can evenually repay he loan, or he borrower defauls and he bank mus wrie off boh he firs loan and he subsequen evergreen loans. In he shor run, he evergreening bank could have lower nonperforming loans and wrie-offs han a non-evergreening bank. In he long run, however, assuming ha he rue saus of he loans evenually is known and he bank has o wrie hem off, a bank ha evergreens loans on average will have greaer non-performing loans and loan wrie-offs han a similarly siuaed bank ha does no evergreen loans or evergreens less. Regardless of he impac of evergreening, a relaionship bank s incenives could lead o relaively higher non-performing loans. A bank s equiy invesmen in a borrower may influence is behavior oward he borrower. To proec he opion value of is claim o indirec sources of revenue from he borrower, a bank wih an equiy invesmen may be more likely o gran a loan, and be less sric in monioring i han a bank wihou an equiy invesmen. As a resul, banks wih equiy invesmens in heir borrowers have higher fracions of non-performing loans. In sum, across relaionship banks, we expec o find relaively higher levels of non-performing loans a he banks wih he highes incenives o evergreen loans. The higher non-performing loans should be associaed wih higher provisions and wrie-offs. In he invenory model, he banks wih he highes incenives o evergreen should show relaively lower provisions for a given level of expeced wrie-offs as hey delay he reserves, loss reserves, and subordinaed deb in capial. Since 1992, he minimum Tier 1 raio is 4% and he minimum Tier 2 raio is 8%. 14

16 wrie-offs wih evergreen loans. They should also show relaively lower wrie-offs for a given level of non-performing loans or loans. In some circumsances, regardless of incenives, banks are forced or enabled o inerrup heir evergreening. 19 This can occur when regulaors change he rules or heir level of enforcemen, he governmen provides capial infusions or oher assisance, or sockholders demand greaer ransparency. The mos obvious proxy for enabling is direc capial infusions. Changes in bank regulaions ha boos he capial raio and provide more room o provision and wrie off problem loans are also enabling. Acions by regulaors o force a permanen or emporary cessaion of evergreening, or by sockholders o demand more ransparency, are harder o observe or measure. When a bank inerrups is evergreening, i will need o declare more ruhfully he exen of is problem loans, begin o wrie off boh he original and he evergreen loans, and provision for a higher expeced level of wrie-offs. Relaive o a bank ha coninues o evergreen, a bank ha inerrups is evergreening should have higher non-performing loans, wrie-offs, and loan loss provisions. In addiion, hese changes should cause discree shifs in he ime series of hese hree aciviies. III.D. Disenangling he effecs of he economy, regulaory inervenion, and incenives The above discussion suggess ha i will be exremely difficul, if no impossible, o idenify definiively which facor (he economy, regulaory inervenion, incenives) is causing any cross secional differences in bank behavior. Firs, all hree facors were a 19 We consciously use he erm inerrup raher han sop because he acions ha lead o a (emporary) hal in evergreening ofen do nohing o change he underlying incenives o evergreen. 15

17 play over our sample period, wih someimes conflicing and someimes complemenary effecs. For example, assuming ha Japanese banks have relaively high incenives o evergreen, he economy, regulaory inervenion and incenives should all lead o relaively higher wrie-offs a he Japanese banks han a he oher banks. This confluence of facors makes i impossible o develop a se of hypoheses ha would uniquely disinguish he hree effecs. Second, i is commonly undersood ha Japanese banks undersae heir non-performing loans, alhough he level of undersaemen may have fallen over he las decade. The undersaemen and is changing level severely hamper our abiliy o make any predicions ha are linked o NPL, a key variable in he model. Third, in he middle of he sample period, he Japanese governmen massively inervened in he banking secor. Because we do no know he exac naure of he discussions and/or insrucions ha he regulaors had wih he banks, we canno predic exacly how hese changes migh affec bank behavior. Moreover hese inervenions may inroduce unpredicable disconinuiies in he ime series we sudy. As a resul, we are lef wih he empirical quesion of wheher we can find differences in he loan loss provision and wrie-off daa across he Japanese banks and beween he Japanese banks and banks from oher counries. Japanese banks may perform poorly relaive o oher inernaional banks because hey have been hi by relaively large shocks (via he economy or regulaory inervenion), or because heir managers respond differenly o exernal condiions. If heir poor performance is due o shocks, he coefficiens ha link loan loss provisions and wrie-offs o heir regressors will be he same for he wo ses of banks. If his is he case, differences in performance are due o differences in he values of he regressors. If Japanese bank managers ac 16

18 differenly from oher bank managers, he coefficiens will be differen. Our inen is o see if any apparen differences among he Japanese banks or beween he Japanese and oher banks are driven by shocks (refleced in he values of he variables) or behavior (refleced in he esimaed regression coefficiens). IV. The daa Seinherr and Huveneers (1994) and Berlin (2000) classify counries as having eiher ransacional or relaionship banking sysems. Based on heir informaion and daa availabiliy, our relaionship bank sample consiss of banks from Denmark, France, Germany, Spain, and Sweden. All relaionship bank daa come from he BankScope daa se. The sample period covers 8 years over In order o assure ha we are comparing similar banks, we only include banks in our sample for which: - The bank is in an OECD developed counry. - BanksSope idenifies he bank as a commercial bank or medium and longerm credi bank. We do no include banks idenified as savings insiuions, real esae and morgage banks, or cooperaive banks. - The bank has a leas one subsidiary ouside he home counry All non-local corporae owners hold less han 10% of oal equiy, or are from a counry wih a similar banking sysem (e.g.: insiuional invesor in one relaionship counry invess in a bank in anoher relaionship counry). - Available bank daa include a leas NPL, LLR, and LLP for five years The opening senence of he Basle Commiee on Banking Supervisions July 1988 repor reads This repor presens he oucome of he Commiees work over several years o secure inernaional convergence of supervisory regulaions governing he capial adequacy of inernaional banks. (Ialics added). Given he close links beween LLP and he capial raio, i is imporan o have a sample where all banks are subjec o he same capial regulaions, i.e. he Basel Accord. 17

19 These crieria leave us wih a sample of 16 relaionship banks: Denmark (2), France (3), Germany (3), Spain (5), and Sweden (3). Appendix A liss he banks. We collec Japanese bank daa from Zenkoku Ginkou Zaimu Shohyo Bunseki (Analysis of Financial Saemens: All Banks) published annually by Japanese Bankers Associaion. This publicaion conains financial daa from he filings of each bank wih he Minisry of Finance, called Yuka Shoken Hokokusho. The sample period is from he March 1992 o March 2002 financial saemens. (Throughou he paper, our convenion is o refer o daa from he March 1992 saemens as he 1991 fiscal year.) For banks ha merged during he sample period, we add ogeher daa from pre-merger eniies. 22 Since consolidaed saemens were required only afer 1999, we use daa from parenonly saemens. We do no include wo banks ha were naionalized during our sample period (Long-Term Credi Bank of Japan and Nippon Credi Bank), since heir provision and wrie-off behavior is so differen from he oher banks and do no represen acions of an on-going enerprise. Disclosure of non-performing loans for Japanese banks began in March 1993, bu he governmen changed he definiion of NPL wice over he years of our sample o include more caegories. (Deails on changes in he definiions are in he daa appendix, available from he auhors.) In his paper, we use a definiion ha is consisen hroughou he sample period: a non-performing loan is a loan o a bankrup or quasi- 21 Banks from Denmark, France, and Sweden do no repor wrie-offs. For hese counries, we derive wrieoffs as WO = LLR 1 + LLP LLR. 22 Bank mergers include Bank of Tokyo-Misubishi, Chuo-Misui Trus Banks, Sumiomo-Misui Bank, and UFJ Bank. For example, for Bank of Tokyo-Misubishi, which was formed by he merger of Misubishi Bank and Bank of Tokyo in 1996, he daa from 1992 o 1996 are creaed by adding hose for Misubishi Bank and Bank of Tokyo. 18

20 bankrup firm, or a loan overdue for 6 monhs. We also conduc robusness ess ha use broader measures of non-performing loans. Japanese banks wrie off loans in hree ways: (1) by charging agains heir loan loss reserves, (2) by direcly wriing off in he income saemen as loan loss charges, or (3) by direcly wriing off in he income saemen as a par of oher curren expenses. The amoun of wrie-offs in mehod (1) can be measured by applying he relaion WO = LLR 1 + LLP LLR. While he amoun of wrie-offs in mehod (2) is idenifiable as a single iem in he income saemen, mehod (3) is no idenifiable since he wrie-offs are aggregaed as oher expenses. Our wrie-off series combines derived wrie-offs from loan loss reserves (from he Yuka Shoken Hokokusho repors) plus direc wrie-offs from he income saemen (mehods 1 and 2 above). For compleeness, we also discuss he resuls of ess using only derived wrie offs from loan loss reserves (mehod 1 only). Daa on capial infusions o he banking sysem are from he websie of he Deposi Insurance Corporaion Japan. 23 V. Are he Japanese ciy and rus banks similar? Two differen ypes of major Japanese banks exis: ciy banks and rus banks. While ciy banks, which are regular commercial banks, engage in banking business only, rus banks have boh banking and rus businesses. 24 Over he period of our sudy, here are no legal differences in he banking business of hese wo ypes of banks, hough rus banks lending is ypically long-erm. For he rus business, rus banks receive and 23 hp:// 24 Daiwa Bank is he one ciy bank ha is allowed o do rus business, however, is rus business has always been very small. As a resul, we keep Daiwa wih oher ciy banks for he analysis. 19

21 manage funds on behalf of beneficiaries. Since rus asses belong o he beneficiaries and no he shareholders, he bank s rus business is no subjec o accouning rules se by he commercial code. Insead, rus banks keep separae books for heir rus accouns. In his sudy, we only use daa ha cover he banking business of he rus banks. 25 We exclude asses, loans and income relaed o heir rus business. 26 The loan loss reserve invenory model implies ha banks provision and wrie-off behaviors vary across he business cycle. Since i is difficul if no impossible o mach exacly cycles across counries, any apparen differences beween banks from differen counries found wih ime series daa esimaes could be due o he business cycle as well as oher facors. As a resul, cross-counry bank comparisons should be conduced using averages across he business cycle. As all banks wihin a given counry are subjec o he same business cycle, ime series esimaes wih banks from one counry are no subjec o his bias. In addiion, ime series daa allow us o es more carefully for a link beween governmen assisance and provisions and wrie-offs. (We will laer see ha across he Japanese banks he 11 year averages for governmen assisance are so small ha hey do no provide any explanaory power over he whole period.) Time series daa also provide a direc es of wheher capial consrained banks more ighly link heir loan loss provisions o preprovision income. (Averages may hide differen behavior in capial consrained years.) The ime series invenory model is: 25 As far as we can ell, he BankScope daa se combines ogeher he commercial and rus aciviies of he Japanese rus banks. 26 Trus banks do make loans in heir rus accoun, and he NPL in such loans (we call hem rus loans ) became subjec o disclosure since There is no loan loss provision for rus loans, and he wrie-off of NPL is direcly charged agains rus fees. Also here are inernal loans made from he rus accoun o he banking accoun. Since ineres raes charged by he rus accoun are ypically higher han call money raes, he inernal loans can be considered as subsidies o he rus accouns from he bank accouns. 20

22 LLP WO i, = β 0 + β1woi, + β 2 ( WO i, β 3LLRi, i, ) = β + β NPL 7 8 i, + β Loans 9 i, + β GDPGrowh β GDPGrowh 4 + β Aid 11 + β Aid + β PPI 12 5 i, + β PPI 6 + µ i, + ε (7) Where GDPGrowh is defined as he annual percenage growh in GDP, Aid equals capial infusions divided by loans, PPI equals pre-provision income divided by loans, and all oher variables are defined as above. We begin our comparison of Japanese banks by looking a proxies for he incenive o evergreen. When we rank he 12 Japanese banks by average levels of equiy invesmen o loans (see Table 1) we find ha all of he rus banks have greaer equiy invesmens han all of he ciy banks. Wihin Japan, we have wo addiional proxies for a bank s incenive o evergreen. The raio of fees-o-loan ineres income and he raio of ne fees-o-oal loans yield similar rankings across he Japanese banks, wih he rus banks a he op and ciy banks a he boom. Thus, we anicipae ha rus banks have greaer incenives o evergreen non-performing loans han do ciy banks. Table 2 provides summary saisics for he ciy and rus banks. The able repors he mean, median, and sandard deviaion of each variable across he wo ses of banks. The far righ column repors he resuls of a -es for wheher he ciy and rus bank means are equal. The firs resul o noe is ha 13 of he 15 -ess are significan a he 1% significance level, one is significan a he 5% level, and one is no significanly differen. Japanese ciy and rus banks are no similar. The firs four rows provide evidence on banks incenives o evergreen. Rows 1-4 show ha rus banks have significanly higher equiy invesmens (10.1% versus 6.1%), higher capial raios (6.3 versus 5.2), higher fee-o-loan ineres income (22.2% versus 11.2%), and higher ne fees-o-loans (0.4% versus 0.2%). Wih he excepion of he 21

23 lower capial raios a ciy banks, each of hese findings is consisen wih rus banks having greaer incenives o evergreen non-performing loans. Rows 5-10 show ha rus banks have relaively higher levels and sandard deviaions of non-performing loans, wrie-offs and loan loss provisions. NPL are 5.8% versus 3.4%, while WO are 2.1% versus 0.9%. These resuls, indicaing a poorer qualiy loan porfolio, are consisen wih he long run effecs of rus banks evergreening more han ciy banks. Figure 1 illusraes he ime series behavior of loan loss provisions a ciy and rus banks. Trus banks provisions are boh greaer han ciy banks provisions and more variable. In March 1998 and 1999 he Japanese governmen provided capial infusions o banks. As a percen of loans hese infusions were greaer (bu no significanly so, see line 15) a rus banks. Banks used hese infusions o provision for and wrie off nonperforming loans ha hey had been evergreening. Afer he infusions, rus and ciy banks provisioning and wrie-offs are similar. Rows 11 and 12 show ha rus banks have lower ne ineres income (0.8% versus 1.5%) and loans/oal asses (52.2% versus 61.1%). To he exen ha hese banks face similar funding coss and charge similar loan raes, he lower ne ineres income a he rus banks may be due o heir receiving ineres paymens on new loans from principal on loans hey evergreen o non-performing borrowers. On an evergreened loan, he borrower pays he same oal ineres bu owes greaer deb o he bank. This reduces he bank s ne ineres income on is loans. Row 13 shows ha rus banks have higher loan loss reserves (3.6% versus 2.3%), bu Row 14 shows ha rus banks reserves are smaller relaive o average wrie-offs (1.7 22

24 versus 2.3). Despie higher average wrie-offs and a higher variabiliy in wrie-offs, he rus banks mainain a lower cushion of reserves. On all measures excep Tier 1 capial, which is offse by heir lower loan loss reserves o wrie-offs, rus banks appear o be more likely o evergreen and o evergreen more han ciy banks. Table 3 repors ime series, cross secional panel regressions based on equaion 7 above. These panel regressions use 11 years of daa for each of he 12 banks (sacked). The regressions are esimaed wih fixed effecs and cross secion weighs. Panel A repors he loan loss provision equaion esimaes and Panel B he wrie-off equaion esimaes. Models 1 and 2 differ only in ha Model 2 includes conrols for pre-provision income. The regressions allow for differen slope coefficiens beween ciy and rus banks. Loan loss provisions (Panel A) a ciy banks are posiively relaed o wrie-offs, bu no o oher variables ha invenory heory predics should affec provisions. The coefficien esimae in Model 1 suggess ha ciy bank provisions, conrolling for oher facors, equal approximaely 61.2% of wrie-offs. Provisions a rus banks are no relaed o wrie-offs. 27 The rus bank provision o wrie-off relaion is insignificanly differen from zero. I equals ( ) in Model 1 and ( ) in Model 2. Insead, provisions a rus banks are linked one-for-one wih governmen aid. We canno rejec ha (Aid + Trus*Aid = 1) in boh regressions When wrie offs are defined as only wrie-offs ou of reserves, excluding wrie-offs aken direcly ou of he income saemen, neiher se of banks has a significan relaion beween provisions and wrie-offs. 28 When Aid is defined as deferred axes, boh ypes of banks show weak (10 percen level) posiive relaions; when defined as land revaluaions, neiher ype shows significan relaions, when defined as oal governmen aid, only rus banks show a srongly posiive significan (1 percen level) relaion. 23

25 The relaion beween loan loss provisions and pre-provision income is insignificanly differen from zero for boh ypes of banks. We canno rejec ha (PPI + Trus*PPI = 0). The daa sugges, hough, ha he relaion for rus banks is weakly more posiive han for he ciy banks (he Trus*PPI coefficien is significan a he 10 percen level). For boh ypes of banks, he LLP o PPI relaion does no differ across high versus low Tier1 raio banks, conrary o expecaions ha he capial consrained banks more ighly link provisions and income. I seems reasonably safe o infer ha rus banks do no follow he invenory model in seing heir loan loss provisions. Insead, hey increase provisions when hey receive governmen aid or when heir pre-provision income allows i. Ciy bank provisions show a significan link wih wrie-offs. In Panel B, neiher ype of bank relaes wrie-offs o non-performing loans or oal loans as invenory heory predics. Wrie-offs a ciy banks are posiively linked one-forone wih governmen aid, and negaively relaed o GDP growh. The negaive GDP coefficien esimae in Model 1 suggess ha a 1 percen incremen in average GDP growh is associaed wih a fall in average ciy bank wrie-offs of 25%. 29 Wrie offs a rus banks have a one-o-one link o governmen aid, 30 bu no link o GDP growh (we canno rejec ha GDP + Trus*GDP = 0). 31 Only he high capial raio rus banks show a (weak) significan relaion beween wrie offs and pre-provision income. We can rejec ha (PPI + Trus*PPI=0) for he high 29 Average ciy bank wrie-offs/loans are ( *1.00)/ = , or -25%. 30 We canno rejec ha he coefficien esimaes for (Aid + Trus*Aid = 1.0) in eiher model. When Aid is defined as deferred axes or oal aid (capial infusions plus deferred axes plus land revaluaions) boh ciy and rus banks show a similar significan posiive relaion. When i is defined as land revaluaions, boh ypes show a significan posiive relaion, bu he impac is larger for he rus banks. This effec is probably driven by he fac ha only one rus bank revalued is land. 31 These resuls do no change when WO excludes he wrie offs aken direcly from he income saemens. 24

26 capial raio rus banks. We canno rejec ha (PPI + Tier1Raio<5*PPI + Trus*PPI=0) for he low capial rus banks, or ha (PPI + Tier1Raio<5*PPI = 0) for he low capial ciy banks. Again, conrary o expecaions, we do no find ha he capial consrained banks have sronger links beween wrie-offs and pre-provision income. When we define non-performing loans as oal repored non-performing loans (he curren definiion is uniform hroughou he period, only including loans o bankrup or quasi-bankrup firms and loans overdue for 6 monhs), he coefficien on NPL is posiive and significan a he 5 percen level in boh models (he NPL coefficien equals (.0419) in Model 1). The Trus*NPL coefficien is never significanly differen from zero. Expanded classificaions of wha is included in NPL over he period boos oal repored NPL and hus no doub cause his correlaion as wrie-offs generally rise over he period as well. An evergreening model appears o explain he wrie-offs of boh ciy and rus banks. Boh ypes of Japanese banks wrie off non-performing loans when hey receive governmen aid o do so. In addiion, ciy bank wrie-offs follow he business cycle (higher in years of slow growh), and high capial rus bank wrie-offs are weakly relaed o pre-provision income. Overall, he daa sugges srong differences beween Japanese rus and ciy banks. They are no uniform. VI. Are he Japanese ciy and rus banks similar o banks in oher relaionship banking counries? Table 4 provides summary saisics for relaionship banks ouside Japan and Japanese banks. The able repors he mean, median and sandard deviaions for he 16 25

27 relaionship banks, and he means for he 7 Japanese ciy and 5 Japanese rus banks (aken from Table 2). The far righ columns provide he es saisics for a -es for wheher he relaionship bank means equal he Japanese bank means. Row 1 shows ha Japanese banks have significanly higher values of equiy invesmens o asses, 6.1% for ciy and 10.2% for rus banks compared o 1.4% for relaionship banks. In addiion, hey have significanly lower capial (Row 2), wih an average Tier 1 raio of 5.3 (ciy) and 6.4 (rus) compared o 7.6 for relaionship banks. Boh differences sugges ha he Japanese banks have sronger incenives o evergreen loans. We nex inquire wheher he repored performance of he banks is he same for each of he hree key measures of he financial performance of loans. Rows 3 and 6 show no differences in he value and sandard deviaion of non-performing loans beween relaionship and ciy banks, he variable ha may be mos easily under-repored by a bank wih a complici regulaor. 32 The value and variaion of rus bank NPL, however are significanly higher han for he relaionship banks (mean is 5.8% versus 3.4%). Rows 4-5 and 7-8 show ha boh ses of Japanese banks have significanly higher values and sandard deviaions of wrie-offs and loan loss provisions han for he relaionship banks. For example, mean (sandard deviaion) wrie-offs are 0.9% (0.01) for Japanese ciy banks, 2.1% (0.02) for Japanese rus banks, and 0.6% (0.004) for he relaionship banks. The higher sandard deviaions for he Japanese banks are due o large jumps in provisions in March 1996 and March 1999 and in wrie-offs in March 32 If Japanese banks were in dire financial condiion, and if Japanese regulaors were complici in hiding he banks rue financial condiion, he repored values for Japanese banks may undersae he rue values. We have no evidence ha relaionship banks were in dire srais and suspec ha heir daa may more accuraely reflec heir acual performance. 26

28 1997 and These paerns are consisen wih he Japanese banks making more evergreen loans, hiding hem, and emporarily inerruping heir evergreening when governmen aid was provided. Rows 9 and 10 may provide addiional evidence ha Japanese banks evergreen heir loans. Row 9 shows ha relaionship banks have a significanly greaer raio of ne ineres income o loans (3.4% compared o 1.5% for he ciy and 0.8% for he rus banks). Row 10 shows ha relaionship and Japanese rus banks have equal raios of loans o asses. The ciy banks have higher loans o asses. Lower ne ineres income a Japanese banks may be due o heir receiving ineres paymens on new loans from principal on loans hey evergreen o non-performing borrowers. Row 11 shows ha he raio of loan loss reserves o loans a relaionship banks (2.9%) is higher han a ciy banks (2.0%) bu lower han a rus banks (3.6%). Row 12 shows ha he relaionship banks have enough reserves o cover 5.0 years of average wrie-offs (he raio of loan loss reserves o wrie-offs), while he Japanese ciy (rus) banks have only enough reserves o cover 2.3 (1.7) years of average wrie-offs. If Japanese banks evergreen loans, hey do no ruhfully declare all non-performing loans o be non-performing, and hey do no provide for hem. By no providing for heir nonperforming loans hey have lower loan loss reserves. The lower loan loss reserve cushion a Japanese banks makes hem more vulnerable o income or credi qualiy shocks, which increases heir incenives o evergreen. In sum, all Japanese banks appear o have sronger incenives o evergreen han he oher relaionship banks, and he daa are consisen wih hem making more evergreen loans. 27

29 III.1.B. Mulivariae Tess using Cross-Secional Daa The univariae ess show ha inernaional Japanese banks are differen from oher inernaional relaionship banks. Are hese differences due o differen economic condiions, regulaory inervenions, or differen managemen pracices? If hey are due o differen managemen pracices he coefficiens in he provision and wrie-off regressions will differ beween Japanese banks and oher relaionship banks. If hey are due o differen economic condiions or regulaory inervenion he coefficiens can be he same bu he average values of he regressors mus be differen. The univariae ess show ha he average values of he regressors differ. We now es wheher he coefficiens also differ. We es for differences beween he relaionship and Japanese banks by esimaing he provision and wrie-off regressions from he loan loss reserve invenory model, allowing for separae inercep and slope coefficiens for he Japanese banks. Because our Japanese ime series resuls sugges significan differences beween Japanese ciy and rus banks, we separaely compare each ype of Japanese bank agains he relaionship banks. And, because we are comparing banks from muliple counries, we use he business cycle version of he model. For each relaionship bank an observaion is an average for he years For each Japanese bank an observaion is an average for he years Since he wo equaions are esimaed for he same se of banks, we use he seemingly unrelaed regression (SUR) mehod o conrol for boh heeroskedasiciy and conemporaneous correlaion across he residuals. 28

30 Table 5 repors he loan loss provision regression and wrie-off regression resuls ha follow from he invenory model. LLPi = β 0 + β1woi + β 2σ ( WO) i WO = β + β NPL + β Loans i 4 5 i 6 i β LLR 3 + µ i + ε (8) We include separae counry inerceps (esimaed inerceps no repored), and a binary variable (JP), wih he value one for Japanese banks, imes each regressor. This mehod allows he Japanese banks o have differen slope coefficiens o reflec differen behavior. Since we esimae he regression wih one observaion per bank, he resuls relae o he cross secional paern of bank behavior averaged over he sample period. Models 1 and 2 include he relaionship and ciy banks, models 3 and 4 he relaionship and rus banks. The relaionship bank counry inerceps (values no repored) are significanly differen from each oher a he one percen significance level in each specificaion. In all Table 5 specificaions, all proxies for governmen assisance o he Japanese banks are never significanly differen from zero, so hey are excluded o preserve degrees of freedom. 33 In Models 2 and 4 we also include GDP Growh and a proxy for he level of regulaory inervenion o conrol for differen counry-level effecs. Our proxy for regulaory regimes, Heriage, is he Index for Banking and Finance from he Heriage Foundaion s Index of Economic Freedom series. The index considers governmen ownership of banks, resricions on he abiliy of foreign banks o open branches, governmen influence over he allocaion of credi, governmen regulaions, and freedom 33 The lack of significance for he Japan capial infusion coefficien is mos likely due o averaging. While capial infusions reached as high as 3.7% of loans for one bank in March 1999, he average across he 11 years for all he banks is only 0.2%. There is one excepion o he lack of significance. When oal governmen aid is included in he wrie-off equaion wih jus PPI (and no GDP Growh or Heriage), hen he governmen aid coefficien esimae is negaive and jus significan a he 10 percen level. 29

31 o offer any and all ypes of financial services. The variable ranges from 1 o 5, wih higher numbers indicaing more governmen inerference. The average value across he oher relaionship counries is 2.3. Japan s average value over he period is 2.8. The expeced relaion beween regulaory inerference and LLP and WO is indeerminae. A highly involved regulaory body could enforce rules sricly, leading o relaively generous provisioning and acive wrie-offs, or could pracice forbearance, leading o relaively lax provisioning and slow wrie-offs. In he loan loss provision regressions (Panel A), he JP coefficien esimaes in Models 1 and 2 are never significanly differen from zero, indicaing ha he Japanese ciy banks behave similarly o he relaionship banks. The esimaes sugges ha loan loss provisions for boh relaionship and Japanese ciy banks are posiively relaed o wrie-offs and he sandard deviaion of wrie-offs, and negaively relaed o beginning loan loss reserves. These paerns are consisen wih predicions of he invenory model. In Model 2, we see no link beween provisions and GDP growh or pre-provision income, bu a posiive relaion wih our proxy for regulaion. Across counries, more inensive regulaory oversigh is associaed wih higher loan loss provisions. 34 Models 3 and 4 in Panel A sugges srong differences in relaionship and Japanese rus bank behavior. Japanese rus bank provisions are more srongly posiively associaed wih wrie-offs. We canno rejec a one-for-one relaionship beween rus bank provisions and wrie-offs, while we can for he oher relaionship banks. Conrary o he significan posiive link beween provisions and he sandard deviaion of wrie-offs for he relaionship and ciy banks, he Japanese rus banks have a significan negaive 34 When included separaely, boh he Heriage and GDP Growh coefficiens have posiive significan coefficien esimaes in he loan loss provision esimaes, for boh ciy and rus banks. 30

32 relaion. We rejec ha ( σ WO + JP * σwo) = 0 a he 10 percen level in Models 3 and 4. Across Japanese rus banks, he banks wih he mos variable wrie-offs have he lowes loan loss provisions. The Panel B resuls for wrie-offs are similar, indicaing lile difference beween he relaionship and ciy banks, bu major differences beween relaionship and rus banks. Model 1 suggess a sronger relaion beween wrie-offs and NPL for he ciy banks a he 10 percen level, bu he significance disappears when we add he oher conrols. In Models 3 and 4, we ge srong evidence ha he rus bank wrie-offs have a sronger link o NPL, and mixed evidence of a difference wih Loans (significan a he 1 percen level in Model 3 and insignifican in Model 4). 35 No evidence is found of a link beween wrie-offs and GDP growh, he Heriage proxy for regulaion, or PPI. The conclusion from hese esimaes is ha here is no significan difference in he loan loss provision behavior of he Japanese ciy banks and he oher relaionship banks. In general, heir wrie-off behaviors are also similar. The only excepion is in some specificaions where he Japanese ciy banks show sronger links o non-performing loans. The relaionship and Japanese rus banks are sarkly differen, wih he differences consisen wih he rus banks evergreening and inerruping heir evergreening. In mos cases, he rus bank coefficien esimaes significanly differ from he relaionship bank esimaes. Japanese rus banks have greaer average wrie-offs han 35 When NPL is defined o include oal repored non-performing loans, he JP*NPL coefficien esimaes are larger and more significan (e.g., he Model 1coefficien is (.031)). When WO is defined as jus wrie-offs aken ou of reserves, he beginning LLR coefficien for he Japanese banks becomes larger and more significan for boh ses of banks. Nohing else changes for he ciy banks. For he Trus banks, he JP coefficien esimaes in he LLP equaion become larger. In he WO equaion, he JP*NPL coefficien esimae is no longer significan. 31

33 relaionship banks, and hey link heir provisions more closely o heir wrie-offs. This difference may be due o he much higher loan loss reserves of relaionship banks, which was noed in he univariae analysis above. Relaionship banks can easily mee heir average annual wrie-offs wih no addiional provisions. Japanese rus banks are less able o do so. As a resul, he average provisions a Japanese banks exceed hose a relaionship banks. VII. Discussion of he resuls The above resuls indicae ha he Japanese banks are neiher uniform nor unique. The daa paerns are consisen wih all hree facors (he economy, regulaory inervenion, and incenives) playing a role. The effec of macroeconomic condiions shows up mos srongly in he ime series daa. Across Japanese banks, wrie-offs are negaively associaed wih changes in GDP. Oherwise, he effec of he weak economy shows up in he values wih relaively higher average non-performing loans and wrie-offs a he Japanese banks han a he relaionship banks. Governmen assisance also had a significan impac on he ime series of Japanese bank behavior. The daa are consisen wih he Japanese banks in general, and he rus banks in paricular, inerruping heir evergreening behavior over his ime period. Trus banks loan loss provisions and wrie-offs are ied one-for-one wih capial infusions from he governmen; hey have relaively high non-performing loans, wrieoffs, and provisions; and he sandard deviaions of hese variables are relaively high. 32

34 The ciy banks also show some evidence of inerruping heir evergreening, wih wrieoffs ied one-for-one wih capial infusions. The daa are also consisen wih differen incenives o evergreen leading o differen behavior, a leas wih respec o comparisons of Japanese rus banks wih banks in oher relaionship counries. Japanese ciy bank behavior, as refleced in regression coefficien esimaes, is indisinguishable from he behavior of banks in oher relaionship counries. (The only excepion is a sronger link beween wrie-offs and nonperforming loans a he Japanese ciy banks in one specificaion ha is probably driven by a lower loan loss reserve cushion a he ciy banks.) Japanese rus bank behavior is sharply differen from boh Japanese ciy banks and oher relaionship banks. Among hese 3 ses of banks, he rus banks have he sronges incenives no o enforce a hard budge consrain. The daa are consisen wih hem making more evergreen loans. If he evidence consisen wih inerruping evergreening a he Japanese banks is rue, he nex logical quesion is wheher or no he rus (and ciy) banks have succeeded in cleaning up heir bank porfolios. While we canno ge direc evidence on his, he indirec evidence is no encouraging. Table 6 repors beginning and ending averages for he hree ypes of banks. While he relaionship banks cu non-performing loans almos in half over he period, he ciy banks almos doubled non-performing loans and he rus banks ended wih approximaely he same level. Noe, when we look a oal repored non-performing loans, he ending period averages are for he ciy banks and for he rus banks. While reserves fell a he relaionship banks, so did heir wrie-offs, so he loan loss reserve cushion rose from 2.5 o 5.7. For he Japanese banks, boh reserves and 33

35 wrie-offs rose, wih he reserve cushion falling o 1.9 for he ciy banks and 2.3 for he rus banks. Finally, despie all he governmen assisance and capial infusions, he Japanese ciy banks ended he period wih an only slighly higher average Tier 1 raio, while he rus bank Tier 1 raio fell slighly. The relaively low capial raios and loan loss reserve cushions for boh he ciy and rus banks sugges ha hey are sill vulnerable o income and credi qualiy shocks. VIII. Conclusion In he 1990s, he Japanese banks were noable because of heir poor performance: low income combined wih increasing problem loans and wrie-offs. Explanaions for his poor performance include he long period of weak macroeconomic performance, regulaory inerference, and incenive effecs on managemen pracices. The purpose of his paper is o see if he Japanese banks are uniform or unique. We compare Japanese ciy and rus banks wih each oher and wih banks from oher relaionship banking counries. The daa show significan differences across all hree ypes of banks in he magniudes of he non-performing loans, loan loss provisions and wrie-offs. These differences are consisen wih effecs from all hree explanaions. The behavior of he Japanese rus and he oher relaionship banks is also significanly differen, suggesing an imporan role for incenives. Ineresingly, he behavior of Japanese ciy banks and oher relaionship banks is almos indisinguishable, suggesing ha apar from he shocks of a weak economy and regulaory inervenion, he Japanese ciy banks are similar o banks in oher relaionship banking counries. 34

36 REFERENCES Allen, Franklin, and Gale, Douglas A welfare comparison of inermediaries and financial markes in Germany and he U.S. European Economic Review. Aoki, Masahiko, Monioring characerisics of he main bank sysem: An analyical and developmenal view. In Masahiko Aoki and Hugh Parick, (eds.) The Japanese Main Bank Sysem. New York: The Oxford Universiy Press. Aoki, Masahiko, Parick, Hugh, and Sheard, Paul The Japanese main bank sysem: An inroducory overview. In Masahiko Aoki and Hugh Parick, (eds.) The Japanese Main Bank Sysem. New York: The Oxford Universiy Press. Barseghyan, Levon Non-Performing loans, prospecive bailous, and Japan s slowdown. Working paper, Norhwesern Universiy, March 30. Basel Commiee on Banking Supervision. July Inernaional convergence of capial measuremen and capial sandards. Berlin, Michell Why don banks ake sock? Business Review, Federal Reserve Bank of Philadelphia, Berlin, Michell, Kose John, and Anhony Saunders Bank equiy sakes in borrowing firms and financial disress. The Review of Financial Sudies. Vol. 9 Issue 3, Boo, Arnoud W.A., Relaionship banking: Wha do we know? Journal of Financial Inermediaion, vol. 9, no. 1, January, Cavallo, Michelle and Giovanni Majnoni Do banks provision for bad loans in good imes? Empirical evidence and policy implicaions. In R.M. Levich, G. Majnoni and C. Reinhar (eds.), Raings, Raing Agencies and he Global Financial Sysem. Boson: Kluwer Academic Publishers. Coravarria, Luis, Claudia Dziobek, Akihiro Kanaya, and Inwon Song Loan review, provisioning, and macroeconomic linkages. Inernaional Moneary Fund Working paper WP/00/195. Dewaripon, Mahias, and Jean Tirole A heory of deb and equiy: Diversiy of securiies and manager-shareholder congruence. The Quarerly Journal of Economics 109: Dewener, Kahryn, and Alan Hess Are relaionship and ransacional banks differen? Evidence from loan loss provisions and wrie-offs. Working paper. 35

37 Hayashi, Fumiao, and Edward C. Presco, The 1990s in Japan: A los decade, Review of Economic Dynamics, vol. 5, no. 1, January, Hoshi, Takeo, and Anil Kashyap, The Japanese Banking Crisis: Where did i come from and how will i end? Macroeconomics Annual The MIT Press (2000) Cambridge. Hoshi, Takeo, Kashyap, Anil, and Scharfsein, David The role of banks in reducing he coss of financial disress in Japan. Journal of Financial Economics 27: Kashyap, Anil K., Soring ou Japan s financial crisis, Federal Reserve Bank of Chicago Economic Perspecives, vol. 26, no. 4, 4 h Quarer, Kim, Myung-Sun, and William Kross The impac of he 1989 change in bank capial sandards on loan loss provisions and loan wrie-offs. Journal of Accouning & Economics 25: Laeven, Luc, and Giovanni Majnoni Loan loss provisioning and economic slowdowns: oo much, oo lae? Journal of Financial Inermediaion 12: Peek, Joe, and Eric S. Rosengren Unnaural selecion: Perverse incenives and he misallocaion of credi in Japan. NBER Working Series, working paper Prowse, Sephen D., Corporae finance in inernaional perspecive: Legal and regulaory influences on financial sysem developmen. Economic Review. Federal Reserve Bank of Dallas Third quarer: Smih, David C Loans o Japanese borrowers. Board of Governors of he Federal Reserve Sysem, Inernaional Finance Discussion paper number 769, June. Seinherr, A. and Ch. Huveneers On he performance of differenly regulaed financial insiuions: Some empirical evidence. Journal of Banking and Finance 18: Wall, Larry D., and Timohy W. Koch Bank loan-loss accouning: A review of heoreical and empirical evidence. Federal Reserve Bank of Alana Economic Review, 2 nd Q. Wilner, Benjamin S The exploiaion of relaionships in financial disress: The case of rade credi. The Journal of Finance LV:

38 Appendix A Sample Banks RELATIONSHIP BANKS Denmark Danske Bank Jyske Bank France Credi Lyonnais Credi Agricole Indosuez Credi Indusriel e Commercial Germany Bayerische Hypo-und Vereinsbank Dresdner Bank Commerzbank Spain Sanander Cenral Hispano Banco Bilbao Vizcaya Argenaria Banco Esp. de Credio, BANESTO Banco Popular Espanol Banco de Sabadell Sweden Svensk Handelsbanken Skandinaviska Enskild Banken AB Nordea Bank Sweden JAPANESE BANKS Sumiomo Misui Banking Corp. Bank of Tokyo Misubishi UFJ Bank Fuji Bank Dai-Ichi Kangyo Bank Indusrial Bank of Japan Misubishi Trus and Banking Corp. Sumiomo Trus and Banking Corp Chuo Misui Trus and Banking Corp. Daiwa Bank UFJ Trus Bank Ld. Yasuda Trus and Banking Corp. 37

39 Figure 1 Japanese Ciy and Trus Bank Loan Loss Provisions Ciy Trus Noe: Graph repors average annual loan loss provisions for he 7 Japanese ciy and 5 rus banks. Daa poins in 1995, for example, refer o numbers from he March 1996 fiscal year end financial saemens. 38

40 Table 1 Raio of Equiy Invesmens o Loans, Japanese Banks Japanese Bank Equiy Inv./Loans Chuo Misui Trus and Banking Yasuda Trus and Banking UFJ Trus Bank Misubishi Trus and Banking Sumiomo Trus and Banking Daiwa Bank Indusrial Bank of Japan Fuji Bank Bank of Tokyo Misubishi UFJ Bank Sumiomo Misui Banking Dai-Ichi Kangyo Bank Noe: Table repors average raio of equiy invesmens o oal loans for Japanese banks over

41 Table 2: Summary Saisics for he Japanese Banks 1. EqInv/Asses JAPANESE CITY BANKS (7) JAPANESE TRUST BANKS (5) Ciy-Trus=0 Mean Median S. Dev. Mean Median S. Dev. T-es *** 2. Tier *** 3. Fee/In Income *** 4. Ne Fees/Loans *** 5. NPL/Loans *** 6. LLP/Loans *** 7. WO/Loans *** 8. σ NPL/Loans *** 9. σ LLP/Loans *** 10. σ WO/Loans *** 11. NII/Loans *** 12. Loans/Asses *** 13. LLR *** 14. LLR/WO ** 15. CapInf/Loans Noe: Table repors Mean, Median, and Sandard Deviaion for he variables across he 7 Japanese ciy and 5 Japanese rus banks. All variables are calculaed as averages over (i.e., one observaion per bank). EqInv = equiy invesmens, Tier 1 Raio = risk weighed capial raio, Fee/In. Income = fee income over loan ineres income, Ne Fees = fee revenues fee coss, LLP=loan loss provisions, WO= wrie-offs, NPL = non-performing loans, NII/Loans = ne ineres income/loans, LLR = loan loss reserves, Loans = oal loans, CapInf = capial infusions from he governmen. Difference in means is esed wih a 2-sided -es, assuming unequal variances. *, **, *** Denoe significan differences a he 10, 5, and 1 percen levels respecively. 40

42 Table 3: Time Series Cross-Secion Panel Regressions: Japanese Banks Only LLP, β 0 + β1wo, + β 2 ( WO) WO i, = β + β NPL i, + β Loans i, β LLR i = i i, 3 i, β GDPGrowh 10 + β GDPGrowh 4 + β Aid 11 + β Aid + β PPI 12 5 i, + β PPI 6 + µ i, + ε Panel A: Loan Loss Provision Equaion Model 1 Model 2 WO (.0031)*** (.0041)*** Trus*WO (.0752)* (.0529)* WO (.3793) (.2331) Trus* WO (.3440) (.2095) LLR(-1) (.5271) (.4833) Trus*LLR(-1) (.8161) (.8037) Aid (.6539) (.7468) Trus*Aid (.0036)*** (.0090)*** GDP Growh (.7019) (.5577) Trus*GDP Growh (.1725) (.3238) PPI (.2450) Tier 1 Raio < 5*PPI (.947) Trus*PPI (.0855)* Adjused R

43 Table 3 Panel B: Wrie-Off Equaion Model 1 Model 2 NPL (.3612) (.5235) Trus*NPL (.3721) (.3853) Loans (.9485) (.9217) Trus*Loans (.3318) (.2885) Aid (.0000)*** (.0000)*** Trus*Aid (.5098) (.1948) GDP Growh (.0002)*** (.0018)*** Trus*GDP Growh (.2446) (.7273) PPI (.4345) Tier 1 Raio < 5 * PPI (.0692)* Trus*PPI (.0512)* Adjused R Noe: Table repors resuls from cross secion ime series panel regressions wih 11 years ( ) of daa for 7 ciy and 5 Japanese rus banks. Panel regressions esimaed wih fixed effecs and cross secion weighs. WO= wrie-offs/oal loans, NPL = nonperforming loans/oal loans, Loans = oal loans/oal asses, LLR = loan loss reserves /oal loans. Trus = 1 for he 5 Japanese rus banks. GDP Growh = average annual GDP growh rae for Japan. Aid = Japanese governmen provided capial infusion (preferred shares and subordinaed loans/loans). PPI = pre-provision income/loans. Tier 1 Raio < 5 = 1 for bank years where Tier 1 raio is less han 5.0. P-values are repored in parenheses below he coefficien esimaes. *, **, and *** Denoe significance a he 10, 5, and 1 percen levels respecively. 42

44 Table 4: Summary Saisics for he Relaionship and Japanese Banks RELATIONSHIP BANKS (16) JAPANESE BANKS Rel-Ciy=0 Rel-Trus=0 Mean Median S. Dev. CITY (7) Mean TRUST (5) Mean T-Tes T-Tes 1. EqInv/Asses *** *** 2. Tier 1 Raio *** 2.576*** 3. NPL/Loan *** 4. WO/Loans ** *** 5. LLP/Loans *** *** 6. σ NPL/Loans *** 7. σ WO/Loans *** *** 8. σ LLP/Loans *** *** 9. NII/Loans *** 5.351*** 10. Loans/Asses *** LLR/Loans ** * 12. LLR/WO *** 4.145*** Noe: Table repors Mean, Median, and Sandard Deviaion for he variables across he 16 Relaionship and 7 Japanese ciy banks. All variables are calculaed as averages over for he relaionship and for he Japanese banks (i.e., one observaion per bank). LLP=loan loss provisions, WO= wrie-offs, NPL = non-performing loans, NII = ne ineres income, LLR = loan loss reserves, Loans = oal loans, EqInv = equiy invesmens. Difference in means is esed wih a 2-sided -es, assuming unequal variances. *, **, *** Denoe significan differences a he 10, 5, and 1 percen levels respecively. 43

45 Table 5: SUR Regressions, Relaionship and Japanese Banks LLPi = β 0 + β1woi + β 2σ ( WO) i WO = β + β NPL + β Loans i 4 5 i 6 i β LLR 3 + µ i + ε Panel A: Loan Loss Provision Equaion REL + CITY REL + TRUST Model 1 Model 2 Model 3 Model 4 WO (.059)* (.195) JP*WO (.403) (.465) LLR(Beg.) (.016)** (.016)** JP*LLR(Beg) (.319) (.277) σ WO (.001)*** (.001)*** JP*σ WO (.933) (.918) PPI (.470) JP*PPI (.867) GDP Growh (.358) Heriage (.000)*** (.065)* (.212) (.001)*** (.001)*** (.018)** (.018)** (.832) (.553) (.002)*** (.002)*** (.004)*** (.009)*** (.460) (.556) (.363) (.000)*** Adj. R

46 Table 5 Panel B: Wrie-Off Equaion REL + CITY REL + TRUST Model 1 Model 2 Model 3 Model 4 NPL (.482) (.602) (.509) (.630) JP*NPL (.050)* (.474) (.0004)*** (.005)*** Loans (.339) (.859) (.372) (.871) JP*Loans (.130) (.539) (.000)*** (.789) PPI (.203) (.233) JP*PPI (.245) (.859) GDP Growh (.937) (.946) Heriage (.244) (.274) Adj. R Noe: Table repors resuls from seemingly unrelaed regressions (SUR) wih 16 Relaionship and 7 Japanese ciy banks in Model 1, and 16 Relaionship and 5 Japanese rus banks in Model 2. All variables are calculaed as averages over for he relaionship and Japanese banks (i.e., one observaion per bank). Separae counry inerceps included in each specificaion. WO= wrie-offs/oal loans, NPL = nonperforming loans/oal loans, Loans = oal loans/oal asses, LLR(Beg.) = loan loss reserves/loans a fiscal year end 1994 for he relaionship and March 1992 for he Japanese banks, GDP Growh = average annual GDP growh rae for ha bank s counry over he sample period, Heriage = average value of he Index for Banking and Finance from he Heriage Foundaion s Index of Economic Freedom series for ha bank s counry over he sample period. JP = 1 for he Japanese banks. P-values are repored in parenheses below he coefficien esimaes. *, **, and *** Denoe significance a he 10, 5, and 1 percen levels respecively. 45

47 Table 6: Beginning and End of Period Averages Relaionship Japanese Banks Ciy Banks NPL/Loans Japanese Trus Banks Beginning Ending LLR/Loans Beginning Ending Wrie offs/loans Beginning Ending LLR/WO Beginning Ending Tier 1 Raio Beginning Ending Noe: Table repors averages across 16 relaionship, 7 Japanese ciy, and 5 Japanese Trus banks a he beginning of he sample period (1994 for he relaionship banks and 1991 for he Japanese banks), and a he end of he sample period (2001 for all banks). NPL = nonperforming loans, LLR = loan loss reserves, WO = wrie offs, Tier 1 Raio = risk weighed capial raio. 46