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Another fine mess
Japan's banking system is tottering again on the brink of catastrophe.

Another crisis nears in Japan
Commentary: Banking system catastrophe looms
By Paul Erdman, CBS.MarketWatch.com
Last Update: 1:29 PM ET March 13, 2003

SAN FRANCISCO (CBS.MW) -- Given the current state of uncertainty that has engulfed the world's financial markets, all we need is yet another crisis.

But one is definitely brewing in Japan.

Sooner or later that nation is going to be hit by a financial crisis of major proportions. Given the facts that Japan's economy is the world's second largest, that Japan is the largest exporter of capital on earth, that the Bank of Japan owns hundreds of billions of U.S. Treasury bonds and notes, a financial crisis there could send new shock waves around the world.

The entire banking system there is tottering on the edge of catastrophe. The situation is so acute that it requires management on a day-to-day basis.

On Wednesday, the Nihon Keizai Shimbun, that country's equivalent of our Wall Street Journal and hardly a publication that has alarmist tendencies, reported: "The Bank of Japan supplied a large amount of funds to the money market today, as it did yesterday, to avoid a systemic financial crisis."

That same day it also reported that an executive of a major bank received a phone call from a close aide to Prime Minister Junichiro Koizume on Sunday who asked: "What emergency steps can the government take to avert a meltdown of the financial system should the stock market crash after the war on Iraq starts?"

At the core of the problem are the Japanese commercial banks. All are grossly undercapitalized. All have huge investments in Japanese stocks, which they still carry on their books at cost.

As the Nikkei sinks ever further, the unrealized losses on their stock holdings keep mounting. They already exceed $50 billion. If the banks were required to mark them to market, the capital that they do have would be for the most part wiped out.

It's not just stocks. The banks also own an unprecedented amount of government bonds, now exceeding 50 trillion yen, bonds that the government has been stuffing down their throats for years in order to finance massive deficit spending programs. Even a slight reversal in interest rates, now at record low levels, would significantly drag down the prices of those bonds, causing the banks to incur enormous losses.

Obviously the banks are in desperate need of additional capital to cover such looming losses. But who would be willing to take the risk of providing it now? Nobody in their right mind. So what are the banks doing? They are lending new money to their large corporate clients, many of whom are suffering huge ongoing losses in their operations and belong in bankruptcy, who then use the funds to buy newly issued shares of their lender. What this amounts to is using the same capital twice. In any other country that would land you in jail for twenty years.

The other source of new capital for the commercial banks is the government itself, including the Bank of Japan. The problem is that the BoJ already has huge holdings of both stocks and government bonds. Which means that the nation's central bank is itself dangerously exposed if stocks prices decline further and interest rates begin to rise.

Overall, the BoJ's assets are proportionally five times the size of those held by the Federal Reserve or the Bank of England. As the BoJ seeks to stave off further declines in the stock market and as it simultaneously seeks to keep the commercial banks above water, the private-sector assets on its balance sheet are bound to grow dramatically to even more alarming proportions. This means that the entire Japanese financial system, not just its banks, will become increasingly suspect.

What Japan needs is a Bill Seidman who engineered the cleanup of this country's Savings and Loan industry a dozen or so years ago even when it required the forced liquidation of many financial institutions. This process played a key role in setting the stage for the great American economic boom of the 1990's. What Japan has gotten, however, falls far short of that.

The new head of the Bank of Japan will be Toshihiko Fukui. He is a typical member of the Japanese establishment, a graduate of the law school of the University of Tokyo that for decades has been producing the bureaucrats who run the country, mandarins who are loathe to ever really rock the boat. What this means is that the Japanese boat will continue to go nowhere but in circles. What the world must hope for is that it will not suddenly capsize and sink in a sea of red ink.