The deterioration of bank balance sheets in Japan: Risk-taking and recapitalization

Abstract

This paper empirically investigates whether the slowdown in the credit supply of Japanese banks during the early 1990s was caused by the deterioration of their equity capital as suggested by the capital crunch hypothesis. This hypothesis predicts that a decrease in capital will induce banks to restrict their credit supply. Panel data of the major banks shows that the banks with lower capital/asset ratios tended to increase their credit supply at a faster rate. Thus, our empirical analysis rejects the capital crunch hypothesis. Rather, it supports the moral hazard hypothesis that an increase in banks' equity capital induces them to take a conservative stance toward the expansion of credit supply. We also observe that, after a substantial decline in their capital base the major Japanese banks issued subordinated debt to recover their capital. Most of the subordinated debt were absorbed by their affiliated financial and nonfinancial companies. The traditional relationships between the major banks and other firms helped the major banks to recapitalize in the face of an increasing non-performing loans in the early 1990s.