Young leaders, ladies and gentlemen, thank you Professor ___, for your kind introduction.

1.Nature of Japan's financial system problem

1) Asset bubble burst, largest in the world history
Today I would like to start my lecture with the nature of problem in the Japanese financial system. That is, speculative bubble of the late 1980's and the subsequent balance-sheet adjustment pressure in the banking and corporate sector.
In the late 1980's, speculative bubble phenomenon hit the entire asset markets in Japan, not only the equity and real estate market, but also golf club membership and fine arts. But undoubtedly equity and real estate bubble brought a severe damage to the economy. Stock prices tripled on average during the last four years of the 1980's, and went down to one-third in the following three years. The equity value peaked in 1989. Also the average prices of land and commercial property in Tokyo metropolitan areas followed a similar pattern and currently they are down over 80% from their peak in 1989. The chart (page 2) shows Japan lost 1,000 trillion yen of national wealth in terms of land, and 300 trillion yen in terms of equity. The upshot was accumulation of non-performing assets in the financial sector. Since traditional Japanese bank lending practice has been heavily based on collateral on real estate, not on a cash flow basis, equity's capital of Japan Inc. was substantively wiped out not only on the borrower side but also on the lender side.

2) Magnitude of NPL in Japan
A number of countries have experienced speculative bubbles and banking crises, with remarkable similarities, but conspicuous differences. From a historical perspective, the magnitude of Japanese non-performing assets is significantly larger than the previous major banking crisis in Japan in the late 1920's and the U.S. in the early 1990s, when major commercial banks including Citibank were in trouble. See chart. (page 3) The Swedish number of 13.2% at its peak may be equivalent to the Japanese, but given the nation's GDP size, Japan's problem can be described as the most serious crisis in the world history.
See the next chart. (page 4) The amount of public funds, 70 trillion yen, which has been made available to address banking crisis at present, but not fully used, is the largest among the past experiences, also its ratio to nominal GDP (14 %) is the highest, which indicates the size of the non-performing loan problem in Japan. Of the prepared public funds of 70 trillion yen, we already lost 16 trillion yen for protecting depositors, 5 trillion yen for buying non-performing assets from failed banks, and 7 trillion yen for bank nationalization.
We should start with the recognition of this grave magnitude of non-performing assets in the weak banking system. Prime Minister Koizumi and his administration have announced that it will concentrate on disposal of non-performing assets. In reality, however, they are basically proposing setting a little more that 12.2 trillion yen non-performing assets off the balance sheet within the next two to three years. This should only be an initial step in disposing non-performing loans accumulated on the balance sheets of Japanese banks. More than 80 trillion yen of so-called category II loans, or substandard loans, on a self assessment basis, which is equivalent of 16% of GDP, concentrates on real estate, general construction, retail/wholesale and non-bank sectors.

3) Prolonged crisis, deflation and competitiveness concerns
Japan's banking crisis distinguishes itself from others in terms of the length of the banking crisis and the recessions that followed. It is commonly said that the average duration of banking crisis in history was 3 - 4 years, and the average length of recession was also 3 years. This contrasts with Japan's case, which has already lasted over a decade. One should note that the prolonged banking crisis may go so far as to endanger economy through debt deflation and decline in industrial competitiveness.

2.Lost Decade (page 5)

1) Chronological review
Surprisingly enough, Japan had experienced no major bank failures in the postwar periods. Banks were protected by the Ministry of Finance under the "Convoy" system, where even the weakest bank could survive under the bureaucratic guidance, i.e., new financial products were permitted to sell when all institution are prepared for them. The system had contributed to Japan's rapid catch up with Western countries after World War II, by way of both building up scarce savings and providing stable funds to promising industries. However, even after the financial deregulation started step by step in 1980s, the system itself and more importantly, mindset of bankers remained unchanged; all kinds and size of financial institutions concentrated on real estate loans, and subsequently suffered from the burst of speculative bubbles at the same time.

a) Denial period 1991-1994
Japan began experiencing sporadic banking failures after 1990 when the bubble burst, but until 1994, these are confined to small institutions. Indeed, the market was filled with optimism that asset prices, and thus collateral value, would sooner or later rebound again and therefore no threat to stability of the financial system despite sharp drop of asset prices. In fact, by that time land prices of central business districts in Tokyo had already plunged to below 30% of its peak value. However, it should be noted that in summer 1992, Prime Minister Miyazaya pointed out that taxpayers' money should be injected for solution of non-performing problem, but publicly and politically his proposal was quickly buried since it was considered as taboo to utilize taxpayer's money for banking system resolution. You can imagine how public mistrust on the convoy banking system sturdily persisted. In this regard, I regret that even if the top leader, Prime Minister Miyazawa, recognized the magnitude of non-performing problem personally, the administration put higher priority on fiscal consideration rather than financial system stabilization. I observe that the decision-making mechanism of Japanese government revealed its structural weakness in solving structural problems.

b) Forbearance period 1995-1997
In 1994, two urban credit cooperatives, Tokyo Kyowa and Anzen, failed. This was a start of the forbearance bank resolution policy because of a unique aspect of the case that virtually all Japanese financial institutions were requested by the Ministry of Finance to join the resolution plan, which was often referred to as "collective contribution (Houga-cho)" by the private sector, where major banks were required to pay for the failed bank's losses even if they were not responsible for the failure. This approach was taken in the subsequent failure cases, in order to avoid introducing public money and attribute responsibility of bank failure to banking industry itself.
At the same period, in 1995, Jusen companies, seven housing loan nonblank corporations founded by major banks and life insurance corporations, went bankrupt. Jusen resolution was the first case in which taxpayer's money (685 billion yen) was utilized to stabilize financial system, partly in order to protect many agricultural financial institutions that had lent Jusen. In this sense, farmers were given a higher priority than depositors in the political process. Ironically, however, intense public resentment made it a stronger political taboo to further use of public funds for banking problems. A good example may be Nippon Credit Bank (NCB), one of major banks, was once bailed out in 1996 by collective contribution approach without public money, however, which turned out to be a failure again in 1998 and eventually nationalized in 1999.

c) Crisis management period 1998-2001
The taboo of public money was not broken until fall 1997 when a major bank, Hokkaido Takushoku Bank, and major broker-dealers, Yamaichi Securities and Sanyo Securities went bankrupt. Coupled with the Asian crisis erupted in Thailand, Indonesia, Malaysia, and rapidly spread to Korea, the fragility of Japan's banking system was evident. Under both international and domestic pressure, the government decided to inject public funds into major banks in December 1997. The amount, however, was only 1.8 trillion yen that was too small to address the capital shortage of major banks. This was the first capital injection into major banks, but it essentially reflected the same old forbearance policy taken by the Ministry of Finance. The amount injected was too small. And the market was also disappointed by the fact that most of 1.8 trillion yen was assigned to the Tier II capital, subordinated bonds, which was apparently inadequate in order to dispose huge non-performing assets on the balance sheet of major banks.
Public opinion was beginning to support a departure from forbearance policy in pampering banks. Interestingly, junior politicians with the ruling party, the LDP, myself included, were also frustrated and became a driving force for change. In the beginning of 1998, we developed so-called Total Plan approach, which included a strict due diligence measure for non-performing assets, establishment of debt servicing companies and drastic improvement of bankruptcy and reorganization proceeding, all of which departed from the past forbearance policy and were intended to push the ministry and banking industry toward a fundamental resolution. An important point was that the reform oriented Total Plan measures were logically heading for nationalization of major banks. In fact, we proposed a legislation of bank nationalization in order to prevent Tokyo-led financial market turmoil.
By that time, the Long Term Credit Bank (LTCB) was clearly failing and the MOF tried to rescue it by forcing merger with Sumitomo Trust Bank and injecting small public capital. It was not only the opposition party members that disrupted bureaucrat's plan, but also strong objections were also raised within the ruling party. Although the MOF desired to discuss the LTCB resolution separately from bank nationalization legislation (Financial Revitalization Law or FRL), but finally all major parties agreed to the FRL based upon the drafts by both the LDP and the opposition parties. The bureaucrats almost unconditionally had to implement the law devised by the junior politicians from both the ruling and opposition parties. Thus, the LTCB was nationalized and its non-performing assets were fully removed in the framework of the FRL.
This case was unprecedented in the Japanese political decision-making process where the National Diet is often called as rubber stamp, meaning that politicians are just following the bureaucrats-made policies. The active junior politicians in the bank nationalization debate were named as "Seisaku Shinjinrui" or "Brats in the Diet." One should note that bipartisanship among politicians made financial crisis management possible. Interestingly, a former Swedish Minister for Financial and Fiscal Affaires, Mr. Bo Lundgren told me the same lessons from his Swedish banking crisis management in the early 1990s.
After the FRL, two major banks were nationalized and sold to the private sector and over one hundred small banks and credit cooperatives failed. Japanese people thus experienced major bank failures and learned how to restore the problem. But while systematic management was made possible under the FRL, the second public capital injection into major banks in 1999 was still insufficient, only 7.5 trillion yen was injected on the basis of lax accounting measures under the Financial Function Early Strengthening Law (FFESL). Since major banks strongly resisted to be controlled by the government, under the FFESL, we failed to recognize the fact of bank's capital shortage since the FFESL created a kind of fiction that public capital injection was to make healthy major banks healthier, without addressing the fundamental capital shortage problem. Major banks' capital problem thus still remains today.

d) Beyond crisis 2002-
After 1999 when major bank nationalization and capital injection completed, optimism grew about the Japanese economy among Japanese consumers and within the government, as equity prices rebounded. This is because cyclical recovery driven by inventory adjustment owing to exports and fiscal expenditure. This was the second short-term recovery during the past decade. If you look at the chart, (page 6) Japan's economy has experienced short-term recession three times during the past decade and a financial crisis emerged repeatedly during each recession period. From the end of 2000 the economy turned downwards because of an IT bubble collapse in the U.S., and banks' capital shortage problem again became a hot issue, as bankruptcy or bail out plans were reported among major listed companies, such as Sogo, Mycal, Daiei and large general construction companies.
However, you can see now, spring 2002, cyclical recovery may be again emerging for the third time during the decade. Repeatedly, a caveat should be placed against optimism. An important point is that inventory cycle benefits only to the manufacturing sector, which only accounts for 25% of the GDP. The GDP has declined throughout the decade, since 75% of the GDP is produced in the non-manufacturing sector, in which non-performing assets are concentrated.

2) Macro policy response

Undoubtedly, the cyclical recoveries experienced during the past decade were supported by macro-economic measures.

a) Fiscal policy
ÊÊFirst, conventional fiscal expenditure, i.e., public works spending. The Japanese government spent 125 trillion yen during the decade in the form of supplementary budget, but a direct impetus from conventional macro fiscal expenditure has repeatedly phased away too easily, which illustrates that Japan's problem is more structural than cyclical. Private risks associated with financial crisis were simply transferred to Japan's sovereign risks. As a result, we will have accumulated debts outstanding in central and local governments amounting to 693 trillion yen by the end of this fiscal year.
In this regard, Prime Minister Koizumi, calling for reform, put first priority on fiscal consolidation and placed 30 trillion cap against annual issuance of national bonds (JGB). Although I agree with his intention, it seems to me that he needs a more careful approach. Market participants share a consensus view that non-performing asset disposition and work-out of ailing industries should come first, and fiscal consolidation come second, since our economic problem was caused by misallocation of resources concentrated on unproductive sectors, and thus enhancing productivity is of utmost importance. It might be dangerous that the Koizumi Administration puts too much political emphasis on fiscal consolidation. I believe at least as long as non-performing loan resolution is executed, fiscal spending should be at least neutral to the economy. Also the policy priority must be shared within the government.

b) Monetary policy
Let's move on to monetary policy. Monetary policy played a significant role in response to the speculative bubble. Let me point out five issues.
ÊÊFirst, creation of the bubble. Some argued that low interest rate policy taken by Bank of Japan, central bank, for the purpose of ensuring the Plaza Agreement in 1985 and the subsequent Louvre Accord in 1987 for exchange rate stabilization, has augmented the scale of asset bubble.
ÊÊSecond, bursting the bubble. Japan's official discount rate was increased from 2.5% in 1987 to 6.0% in 1990. Some observes that the timing of the hike was substantively delayed by the political pressure and if not, the bubble would have been much smaller.
ÊÊThird, post bubble reaction. It took over 5 years for Bank of Japan to decrease official discount rate from 6% to 1% level. It is commonly said that Federal Reserve Chairman Greenspan in the U.S. scrutinized Japan's experiences and in 2001 he dropped discount rate from 6% to 1.25% only within one year, which makes a contrast with Japan's experience.
ÊÊFourth, bank's profit. Lowering the short term rate after the bubble burst obviously helped banks profits. The bank's augmented earnings thanks to the fat spread generated the funds necessary for provisioning huge non-performing loans.
ÊÊFifth, quantitative easing and inflationary targeting. In my opinion, recent quantitative monetary ease failed to boost the economy because of malfunctioning financial intermediation, that is, accumulation of huge non performing loans. It might be wise to take further easing after the resolution proceeds in full scale. Theoretically deflation is monetary phenomenon in the long run, but in the short run it is created by real economic factors, over supply and demand shortage in the market of goods and services.

3. Reality of Japan's Banking problem

Let me turn to the banking problem. There are lots of myths and misleading information.

1) Capital shortage, deferred tax, public capital
First. Bank's capital. The Financial Services Agency (FSA) issued the outcome of the special inspection of major banks on April 12, which was focused on 149 large indebted companies concentrating on the non-manufacturing sector. According to the FSA, however, no major banks are undercapitalized. As a superficial matter of BIS standards, capital might be sufficient. But in reality, in the major banks' Tier I core capital of 18 trillion yen, two tricky items are included. That is, 6 trillion yen of deferred tax assets, which represent allowances for the future income tax deduction, and 5 trillion yen of public fund, which is not common stock and therefore has to be reimbursed in the future. In sum, true core capital of major banks is only one third of the stated 18 trillion yen. That's why market participants consider that additional capital injection to be necessary to the major banks.

2) Weak earnings, lack of risk based pricing, low ROE
Second, weak earnings. Japanese banks' return on equity (ROE) is below 15%, which is substantively low compared with U.S. banks which generally keep over 25%. See chart. (page 7) This was mainly caused by three factors. Low interest rate spreads, low service fee earnings, and high credit cost. I would like to emphasize the fact that since Japanese banks lending practices have traditionally been based upon collateral valuations, there is no effective risk based pricing model.

3) Governance problem, Mizuho case
Third, corporate governance. As a result of mega mergers, over 15 major banks are now consolidated into four big groups. But I think recent Mizuho case, where ATMs and fund transfer computer systems clogged because of insufficient system integration testing, casts a new governance question in the banks' mega merger, since the trouble apparently could be avoided if the new management had the merger preparation process in order. Also it is reported that although computer system experts had in the early stage warned the trouble might occur, top management ignored that voice in order to keep the schedule unchanged. We may have to rebuild the governance system that can strengthen resilience of Japanese firms.

4) Cross-shareholding, BSPC
Along with life insurance companies (Seiho), Japanese banks are one of the largest investors in the stock market. The banks hold over 40 trillion yen equities on their balance sheet for the purpose of maintaining long term relationship with the borrowers, but in reality they proved to be unprofitable assets. Thus, banks are expected to sell outright over 4 trillion yen within 2 years. At this juncture Bank's Shareholdings Purchase Corp., government sponsored equity purchasing entity, was established early this year in order to prevent massive wave of selling from putting further downward pressure on the stock market. In my opinion, it is ridiculous. This simple share price supporting mechanism addresses none of the fundamental problems associated with the cross-shareholding and double gearing between banks and life insurance companies. Enhancement of corporate governance and improvement in transparency through full disclosure with reliable accounting system is the only way to solve the structural problem.

4.Way Out

1) Common experience, i.e., U.S., Sweden, and Korea
In order to get out of the current crisis situation, what must we do now? Conventional wisdom is apparent that it is just through the disposal of non performing assets, putting the real assets, for example, real estate, or viable divisions of failed corporations, back to work in the real economy in an efficient way.

Then, how to do it? The answer is also quite simple:

1. Establish stringent rules, provision sufficiently, and recognize losses
2. Remove NPLs off balance sheet, and if necessary nationalize banks or inject public capital
3. Revitalize asset markets, by way of tax and legal system improvement

These measures were adopted in the U.S., Sweden, and more recently Korea. Especially, in Korea, 7% of the GDP has already been spent to clean up the balance sheets of the banks. Aggressive asset disposal was quite effective in de-leveraging the corporate sector in Korea. As to bank restructuring, the Korean government took aggressive actions, such as, capital reduction, drastic business re-modeling, management from outside the banks, and compulsory mergers.
We already know what we must do.

2) Everything is politics
As massive political scandals broke out in the Diet in these days, Prime Minister Koizumi and his administration seem to lose real political determination to proceed with the resolution. In this sense, Japan's situation is such that "everything is politics." As I mentioned, every market participant acknowledges that bank's core capital is composed of one-third of deferred tax assets and one-third of public fund, which means if accounting changes, capital shortage must be recognized and a crisis can suddenly emerge, meaning any political switch can be a possibility for drastic changes in the course of reform.

3) Weak capital market function
It is apparent that when a banking system does not functioning well due to huge non-performing assets, capital market should play an important role as an alternative financial intermediary. Japan's capital markets, however, have failed to attract not only overseas but also domestic investors. See chart. (page 8) Of the 1,404 trillion yen household financial assets, only 7.2% is in equity markets and only 2.3% is in mutual funds, while 53.8% is in bank deposits and postal savings. Let me make four points.
ÊÊFirst, investors don't trust Japan's accounting system. This must be improved, such as, quick introduction of accounting rule for impairment of fixed assets
ÊÊSecond, creation of strong and independent SEC is necessary to protect investors.
ÊÊThird, an independence of mutual fund industry from parent broker dealers must be promoted for the purpose of enhancing transparency and restoring trust of investors.
ÊÊFourth, capital gain tax should be effectively reduced to zero as long as the Japanese economy lacks risk capital in macro economic terms.
I believe that as long as Japanese banks prove to have no capacity to manage assets well, we have to improve capital market.

5. Future scenario (page 9)

In conclusion, I would like to show you three possible scenarios for the course of reform in the financial system.

1. "Compulsory and aggressive" resolution, just like Korea.
2. "Muddle through" approach, continue to conceal the current crisis situation, just like now.
3. "Preemptive," sporadic nationalization, hopefully Sweden cases.

Many of you might think my remarks today as too pessimistic about the future of Japanese financial system reform. In the short term, I must admit that. But in the longer term, that is not correct. I have a bit more optimistic view in the long run, since the problems we are facing now are caused by the speculative bubble burst. From the Tulip bubble in Dutch in 17th century and the South Sea bubble in England in 18th century, various forms of economic bubbles have occurred, but history tells us that no nations have disappeared or declined simply due to the bubble burst, although scandals or political disruptions inevitably broke out. However, behind the prolonged crisis lies our governance problem not only in business sector but also in political sector. As a ruling party politician, I believe what is most needed now is a political will to restore the functions of financial markets for the sake of national interests.

Thank you.