A Note on the Bad Loan Problem

Ryoichi Imai

International Student Center, Kyushu University

2002/11/09

What is the bad loan problem ?

Here are typical balance sheets of firms and banks in 1990.

In 1990, both land and stock prices were still high, and firms and banks have large balance sheets.

In this case, there is no risk of bankruptcy. The equity capital ratio for the bank is 200/600=33(%), which clears the BIS standard.

The BIS (Bank for International Settlement) is an international organization that supervises banking business in the global markets. 

It determines the BIS standard on the equity capital requirement for banks in national and international business.

Today, all banks in the international business must keep an equity capital ratio of higher than 8 %.

However, all banks doing business only within their home countries, must maintain an equity capital ratio of higher than 4 %.

In 1990, when both land and stock prices were extremely high,  it was easy for Japanese banks to clear this standard.

After 1990, land and stock prices continued to decline. For example, the Nikkei, the most popular stock index of Japan, hit its peak at 38900 in late 1989, but fell down to such a low level slightly higher than 8000 in October 2002.

The situation has changed as follows.

Many firms suffer from the decline in land and stock prices. Some of them even record zero equity value, which means that they have less assets than liabilities. 

In this example, the firm originally owed 400 to the bank. But now its assets have value of only 300. Therefore, it can pay only 300 back to the bank.

The bank has to evaluate its loans down to 300. Now the bank's assets have value of only 430. However, it owes 400 to the depositors like us. Then the bank's equity capital ratio is now 40/440=9(%), which only slightly clears the BIS standard.

Recently, Prime Minister Jun-ichiro Koizumi appointed Heizo Takenaka as the minister of economy and financial industry. He organized an executive committee to discuss the bad loan disposal. 

The committee was close to announce a fundamental plan to restrict the deferred tax arrangement in the banks' accounting. 

Until today, the tax authority of Japan has allowed the banks to include a large portion of their deferred tax in their equity capital. 

What is the deferred tax? The following case illustrates how it works.

Assume that the bank has recorded profits of 150, which are, of course, parts of the bank's equity capital.

However, the bank holds some bad loans. It expects that 50 will be lost in the future. Therefore, it decides to save 50 as loan-loss reserve. 

Let 50 % be the corporate tax rate. Then the tax authority recognizes 150+50=200 as the bank's profits, and orders the bank to pay 100 as the corporate tax. 

However, the bank expects that a loss as much as 50 will be realized in the future, and so, it expects that 25, 50 % of the loan-loss reserve, will return from the tax office in the future. This amount, 25, is referred to as the deferred tax.

Until now, the bank is allowed to include a large portion of the deferred tax in its equity capital.

The plan of the "Takenaka Committee" is to reduce the portion of the deferred tax to be included in the bank's equity capital.

The new accounting procedure is crucial to the banks' business, since, in fact, some large fraction of their equity capital consists of the deferred tax. If the deferred tax accounting were dramatically shrunk, many banks would fail to clear the BIS standard, and be forced out of international business.

If the new plan were enforced, the equity capital ratios of most "city banks" would be re-calculated down to less than 8 %. In that case, the government would put public funds into the banks' balance sheets, which means that the government would own those banks exclusively. Then the present members in the executive board of the banks would be fired, receiving no retirement bonus.

This scenario scared the executives of the major banks. The Diet members of the ruling party, the Liberal Democrats, were also against the plan.

Under this circumstance, Takenaka failed to announce the plan, and was forced to revise it into a more moderate, but less drastic one.

The ways to deal with the bad loans

The "Indirect" Disposal

Assume that the bank expects that it will can collect only some portion of the money lent to a firm. Then the bank can prepare for the future loss by saving that amount of money as the loan-loss reserve.

The bank usually maintains its relationship with the firm even if it classifies its loan to that firm as "bad". In other words, it might subsidize the inefficient firm that cannot survive the market competition. 

Therefore, major finance experts share a view that holding loan-loss reserves is not the final disposal of bad loans at all.  

The "Direct" Disposal

The final disposal of bad loans is to "write them off" the bank's balance sheet.

There are three ways to write off the bad loans.

First, the bank can request the court to start the clearance procedure of the borrowers of non-performing loans. In this case, the collateral will be eventually sold at auction, and the borrowing firm is forced to stop its business. The top executives of the borrower will be fired.

Second, the bank can sell the non-performing loans to someone. Who would buy such bad loans ? At what price ? In fact, the only potential buyer is the Resolution and Collection Corporation (RCC), a public organization founded and owned by the Japanese government. It is one of the most crucial issues to determine the pricing system the RCC will use to purchase bad loans from financial institutions.

There are four different pricing methods.

1. The book value: If the bank can sell its bad loans to the RCC at their book value, it is the best outcome for the bank, while all the expected loss will be compensated by tax payers' money.

2. The book value minus loan-loss reserve: If only some portion of the expected loss were covered by the loan-loss reserve, this price would be very comfortable to the bank. The leaders of the ruling party seem to support it.

3. The borrower's fundamental value calculated by the discounted cash flow (DCF) method: Assuming that the borrower continues its business, one can evaluate the firm's market value by adding up its cash flows accruing from now on. This price is usually termed as the loan's market value.

4. The borrower's liquidation value: This is the value that would be realized in the collateral sales.

Until recently, the RCC has mainly used the fourth pricing system, with which financial institutions have been reluctant to sell their bad loans.

The Financial Service Agency (FSA), which supervises Japan's financial institutions, now considers to adopt a new pricing system that helps to accelerate the bad loan disposal.

Third and finally, the borrowers might receive debt-waiver. This choice seems to be the worst one for the bank. However, the fact is different. 

To be continued.