Japanese banks are discovering that their dizzying ascent in the last decade brought them not to the promised land but to the brink of disaster.

Everywhere they turn, Japan's banks find more problems. Morale been sapped by a series of financial industry scandals, and balance sheets have been drained by mounting losses from bad real estate loans.

Five years of interest rate deregulation have eroded operating margins, and tumbling stock prices continue to eat away at the unrealized securities gains that make up almost half of Tier 2 capital at many banks.

Meanwhile, the nonbank financial companies that were funded by the nation's banks are in trouble, too. The industry has tens of billions of dollar exposed - and perhaps hundreds of billions of dollars.

|Meltdown Is Possible'

"In theory, a financial meltdown is possible," said John Choy, an analyst for the government-funded Japan Economic Institute. "There's a lot of speculation that one failure could start a chain reaction" that would topple one institution after another.

Still, most analysts, including Mr. Choy, say that kind of doomsday scenario is unlikely to be realized in a country of protective regulators.

"My guess is that the Ministry of Finance would step in and help in any way necessary," Mr. Choy said.

Yet it is undeniable that Japan's banks, after a decade-long rise to global preeminence, are under considerable pressure. Worldwide, they are pulling in their horns, scaling back loan growth, and raising concerns in some quarters that they will no longer play the vital role they once fulfilled as banker to the huge U.S. budget deficit.

Unstable 'Bubble Economy'

What happened? The "bubble economy" of the 1980s may well have carried the seeds of its own destruction. "It was a true bubble economy," said Arthur Alexander, president of the Japan Economic Institute. "It just fed on itself."

Japanese banks, benefiting from their nation's prodigious ability to save, had plenty of money to lend. Interest-rate deregulation was cutting into margins, and banks, as a result, were looking for investment opportunities that offered better rates of return.

The real estate market looked as though it would spiral upward forever, and Japanese banks -- despite their traditional conservatism -- jumped in readily. Banks not only funded all manner of real estate loans but also increasingly began to lend against properties that were already mortgaged.

With land values seemingly poised to continue rising as far into the future as one could see, bankers began lending against expected future values rather than cash flows.

By the beginning of the 1990s, it was not unusual to find that four or five banks had extended credit against the same property, often without the knowledge of the more senior creditors.

"It is very difficult to explain," said Shuichi Sugara, senior vice president at Sakura Bank Ltd.'s New York office. "But if you were a Japanese banker and your competition was making those loans, you would do the same thing as your competitor."

Moody's Investors Service said loans to real estate companies rose from 6.6% of domestic loans in 1984, to 10.3% in 1990.

At the same time, banks began backing finance companies that also invested heavily in real estate. At Sept. 30, 1991, according to Moody's, 40% of the loans made by nonbank financial companies were real-estate-related.

Not surprisingly, Japan's bank regulators began to worry that the system was spinning out of control.

Pricking the Bubble

In mid-1990, the Ministry of Finance began pushing up interest rates in an attempt to put the brakes on what appeared to be reckless investment practices. It doubled rates within a year.

Also in 1990, the Ministry of Finance restricted loans to real estate companies and nonbanks, The resulting credit crunch wounded the real estate sector, touching off a spree of bankruptcies that crippled the banks.

At the same time, the stock market began to crumble.

From a high of more than 40,000, the Nikkei index had fallen to just below 17,000, and many observers believe it has not yet hit bottom.

Dependence on Market

When the market was moving skyward, banks enjoyed huge gains on their stock portfolios -- profits that could be realized only if those holdings were liquidated.

By terms of the Basle accord on international capital standards, banks were permitted to count those gains as capital, for up to 45% of their Tier 2 requirement, though the gains could vanish if the market turned.

When the market did break, declining stock values brought many institutions perilously close to the 8% fully-phased-in minimum capital ratio they must meet by next July 1.

Standard & Poor's Corp. has said each 1,000-point drop in the Nikkei index reduces the average bank's capital ratio by 10 to 30 basis points.

Most vulnerable to the stock market decline are "city banks," institutions comparable to commercial banks in the United States. Some have already slipped below the 8% standard. Sakura, for example, held risk-adjusted capital of 7.94% at March 31, according to S&P.

Others were right on the edge, such as Fuji Bank, with 8.04%, and Sanwa, with 8.1%. In view of continuing declines in the Nikkei, some of those banks are undoubtedly below the 8% standard by now, according to Japanese bankers.

"At one time, our capital may have dropped below 8%," acknowledged Hidehiko Ide, chief representative in the Fuji Bank Ltd.'s Washington office. "But we are confident that it will return to the required level."

With the market in the doldrums, banks are unlikely to be able to raise capital by selling common stock. Instead, Fuji Bank and its peers must look at a variety of measures, including cost-cutting, asset sales, and the issuance of securities, such as subordinated debt.

Most analysts assume that Japanese banks still have a way to go before the unrealized gains hidden on their balance sheets turn into unrealized losses.

Not Underwater Yet

"The stocks were purchased over a long period of time, so most of the portfolio is still worth more than the banks paid," said Karen Shaw, whose Washington-based company, the Institute for Strategy Development, works for a number of Japanese banks.

"Probably when the Nikkei hits 12,000 to 13,000 is where it tips," said the Japan Economic Institute's Mr. Choy.

But like so many other items in the financial condition of Japanese banks, guesses about the break-even point for stock holdings are just that. Because of the unusual nature of accounting practices at Japanese banks, it is by no means clear how deep the damage runs.

Regulators have limited current information because they examine banks every three years on average, according to S&P. And accounting practices tend to obscure the true financial condition of Japanese institutions, particularly regarding asset mix and quality.

"There's no public information on nonperforming loans," said Moody's analyst Deborah Kinzer. "We think that some of the weaker banks have problem loans of more than 10% of the loan portfolio. The stronger banks have less."

In part because the markets were growing jittery over the lack of information about potential real estate losses, the Ministry of Finance released an estimate that nonperforming loans industrywide totaled in the neighborhood of $59 billion.

"That was pretty much laughed off," said Mr. Choy.

To give the market more credible numbers, the Bank of Japan then leaked -- according to Japanese press accounts -- new estimates with much larger numbers.

The nation's 12 largest banks, it was said, might have bad loans of as much as $262 billion. The entire industry was carrying $311 billion to 418 billion in nonperformers, according to these estimates.

More Sources of Woe?

Even so, some analysts wonder whether the situation is worse still. Banks often advance money to cash-strapped borrowers -- who then use it to make loan payments. The advance is simply added to principal, and the credit continues to be classified as performing.

Moreover, nonbank financial companies created during the boom years of the 1980s are heavily invested in real-estate-related loans, the most troubled sector of the Japanese credit structure.

Again, because of the industry's uninformative accounting practices, the potential exposure is unknown.

The Japanese economy's slowdown has created other strains for Japanese banks. If forced to choose between the safety of the banking system and the strength of the industrial sector, the Japanese system favors the folks who make steel and autos over those who make loans.

As a result, Japanese banks -- with the support of their supervisors -- go in deeper and deeper to customers who would curl the hair of U.S. regulators.

A History of Forbearance

"If a company has a principal bank, the bank will help it through difficult times," said Fuji Bank's Mr. Ide. Companies with longstanding ties to banks can expect their lenders to cut interest rates or otherwise restructure loans until prosperity returns.

A principal bank, said Mr. Ide, "takes the moral responsibility" for pulling companies through hard times.

Looking ahead, views are mixed on how the government will handle the current crisis. Many analysts, including Mr. Choy of the Japan Economic Institute, believe it unlikely that authorities will permit any major bank to fail.

If that proves true, he said, the industry will be unable to address its most fundamental problem: overcapacity.

But Ms. Kinzer, the Moody's analyst, said the Ministry of Finance appears intent on using the crisis to bring about a significant restructuring of the financial system, including a number of mergers.

The result, according to a Moody's report, could be "a reduction in the size and role of the banking industry."Japan's Top FiveRanked by assets;dollars in millions Fiscal year ending Percent World 3/30/92 3/30/91 change rankDai-Ichi Kangyo Bank $446,211 $428,167 4.2% 1Sumitomo Bank 427,585 409,161 4.5 2Sakura Bank 420,823 408,754 3.0 3Fuji Bank 419,430 399,545 5.0 4Sanwa Bank 412,170 402,699 2.4 5Source: American Banker

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