Financial fragility and recent developments in the Japanese safety net

Abstract

The bad loan problem of the early 1990s has revealed the fragility of the Japanese banking system.This paper examines how the safety-net mechanism operated by the Ministry of Finance (MOF) created this fragility. Although the safety net protected most depositors and other investors from losses associated with bank failures, MOF did not implement prudential regulations to prevent moral hazard that this comprehensive safety net was likely to elicit from bank management.The personal ties between regulatory authorities, particularly MOF, and private banks, cemented through the so-called amokudari system, were not effective in disciplining bank management. Rather; the amakudari system reduced bank capital and thereby made the banking system more fragile.This fragility did not come to light during the high growth period because stringent competitionrestricting regulations worked to support the fragile safety net. However, deregulation and structural changes in domestic financial markets removed this support.Thus, as financial deregulation proceeded, it became increasingly likely that the potential fragility would surface. The extremely easy money policy since the mid-1980s and the drastic move to a tight money policy after the late 1980s were just the prelude to turmoil in the Japanese banking sector