"Liberalization" characterizes all the recent policy changes in Japan's financial system.

Judging from recent comments by Masaaki Tsuchida, director-general of banking bureaus in the Japanese Ministry of Finance, the liberalization trend extends to administration, interest rates, product development, management, and reorganization.

There is apparently no voice publicly opposing deregulation and liberalization in Japan. Although the management of financial institutions may be wincing in secret, they don't want to show their weakness by opposing the policy.

Mr. Tsuchida points to several factors on the dark side of deregulation:

* Excessive competition for profits.

* Loss of managerial discipline.

* Lowering moral standards for employees of financial institutions.

As the West is well aware, these phenomena came to light in a criminal case and several other scandals that shocked the Japanese people.

Liberalization has brought about fiercer competition, in some ways making it more difficult to manage Japan's financial institutions.

Deposit interest rates have stayed higher, leading to poor results for the weaker midsize and smaller institutions.

Mr. Tsuchida's bailiwick, the Ministry of Finance, aimed to create a sound environment for financial institutions. The ministry urged credit unions and credit banks, in particular, to streamline their management. As a safety net, mutual assistance and deposit insurance were sanctioned.

Criminality Not Foreseen

Scholars, critics, and practitioners - including Japanese government officials - never expected deregulation to cause a rise in criminal cases in Japan.

Of course, all of Japan had studied the United States S&L scandal of several years ago. So the nation as a whole should have realized its own risk of facing a similar problem.

The S&L crisis in Japan led to many court proceedings, followed closely by its national newspapers.

At that time, two years ago, Japan was holding its first financial consultation with the United States. On the U.S. side, there was a demand for immediate liberalization of deposit interest rates.

Japan could not not accept this demand. If interest rates were liberalized so recklessly, the Japanese negotiators argued, it would experience a rerun of the S&L crisis.

The American side replied that the S&L crisis was caused by poor management, not liberalization of interest rates. To Japan, this line of reasoning just wasn't convincing.

Therefore, Japan refused to succumb to this demand, saying it would deregulate its system at the Japanese pace.

Weaknesses to Uncover

Japan now admits, in retrospect, that at least 50% of the U.S. position was true. As Mr. Tsuchida expressed it at the recent American Banker conference in Tokyo: "Poisonous mushrooms do grow on the soil of deregulation: poor management and the moral degradation of bank employees."

From the Japanese perspective, deregulation on the international level also required deregulating its high-echelon national markets. Japan probably also had as great a need to deregulate the managerial control of its financial institutions.

Guidelines for risk management play an important role in Japanese regulation, aimed at strengthening capital-adequacy rules and restrictions on credits.

In past years, when the Japanese market was gloomy, no one was brave enough to talk about greater discipline for managers and workers of financial institutions.

Management in Japan was too busy trying to keep up with competition in the same industry. Discipline in the front line was weakened - and that led to criminal offenses in the securities area.

To repair the damage, Japanese banks and other financial institutions are working toward a high level of consistency in their profession. But, if worker discipline declines, Japan recognizes that they will have no profits to report.

Of course, only a handful of financial institutions were involved in Japan's criminal offenses. But Mr. Tsuchida expressed the hope that these events will teach a lesson, so that no other financial institutions repeat these same offenses.

As deregulation continued, Japan began to suffer from side effects. Foreigners say Japan is going too slowly with deregulation, and so do some leaders on the domestic front.

Profits were declining for the past two years for Japanese banks - as well as for securities, credit, and leasing companies. Assets also declined for these banks, for many reasons - some of them just temporary, due to cyclical reasons.

In the past two fiscal years Japan's domestic interest rate has gone up, bringing up capital costs with it. Interest revenues from lending, on the other hand, did not grow as much as they used to, because of the credit crunch. That explains the decline in bank profits.

Prospects Under BIS Rules

Regulations of the Bank for International Settlements, effective at the end of 1992, might prevent Japanese banks from recovering their profit levels of the past. But their sales efforts might cause credit demands to go up - possibly reducing the interest rate.

Mr. Tsuchida acknowledge the difficulty of making accurate predictions, but he noted: "I think our people are trying to raise the interest rates.

"If bank lending is suppressed, other lenders such as credit associations are working hard to gain a larger share of the business."

When interest rates fail in Japan - as seems likely to happen in the near future - the spread can be expected to grow even wider. But Mr. Tsuchida maintains that internationalization and legalization of financial markets caused the major impact.

This is also the case in other countries, where financial institutions are losing their competitiveness and heading for a decline due to liberalization of the financial market. Perhaps, Mr. Tsuchida suggests, they forgot all about a prudential management style, and they're about to do anything.

Japanese institutions have moved slowly toward an international focus. Until very recently, they were only comfortable doing domestic business. Prior to 1989, Japan's monetary policy stimulated the growth of assets, meaning that profits kept expanding.

In those days, the stock market kept rising - but now it's in a plunge. The environment is suddenly quite different, and Japanese banks are facing great challenges.

Mr. Tsuchida emphasizes that the "bubble" economy must not return. "We must not stop the flow of liberalization," he told the recent conference audience.

Japan's profit decline is not going to be temporary - it's a structural phenomenon. Banks, as well as the administration authority, will have to begin from scratch to readdress the situation.

Role of Securitization

As noted earlier, financial internationalization and liberalization were cited as reasons for Japan's profit decline. The securitization of finance has also played an important role.

At any time before mid-year 1991, securitization usurped many opportunities for lending from Japan's banks. The future of securities from this point forward is very difficult to predict:

* When do the general investors come back to the market?

* Will major securities houses continue to have influential power?

* When will new securities houses make their entrance, and at what price?

By and large, Japanese financial institutions are not pessimistic. Looking forward, Mr. Tsuchida assured his audience, they will be able to cope with the rate of liberalization.

At this point, Japanese banks have adequate fundamental strength to support the Japanese economy. The economy, in turn, will support the international strengths of the Japanese banks.

Only a handful of Japanese financial institutions are connected to the nation's scandals. They will incur losses, but less than predicted in Japanese newspapers. It will not falter the managerial basis of those financial institutions.

"This situation is really sobering," Mr. Tsuchida said. "The Japanese people have placed an enormous responsibility in our hands.

"As deregulation progresses, over the next two or three years, we'll have to watch how well these financial institutions cope with the challenges.

"I'm sure the companies will bring about success. The management of small financial institutions are keenly aware of the needs, cautious, and very serious - not just sitting and doing nothing."

Credit Unions Promising

Japanese bank profits declined in 1990. But credit associations registered profit increases, so they still have more time. The Ministry of Finance is encouraged by this sign.

The average credit union in Japan is larger than the average American commercial bank. It is more likely, therefore, that credit unions will endure in Japan than in the United States. Banks compete with credit unions in our country, but not on an even playing field.

Japan also has credit associations, financial institutions associated with agricultural cooperatives, and workers' banks - all with somewhat different activities.

"Irresponsible critics say there's no future for small financial institutions," Mr. Tsuchida noted. "Some of the mass media say the Ministry of Finance is wrongly trying to protect the least effective smaller institutions.

"If one financial institutions goes wrong, it has an effect on nearby competitors, possibly making it harder to raise funds or attract core deposits. For that reason, the failure of even one or two small institutions should not be taken lightly."

Voluntary Mergers

Many credit banks are seriously considering mergers, particularly over the past three years. Only a minority of these cases are forced to merge because of poor management and poor results. Most major players would be strong enough to continue in the black, even without a merger.

Newspapers in Japan devote extensive coverage to major bank mergers. But when small institutions get together, locally, Japan's national papers look the other way.

From the perspective of the Ministry of Finance, local mergers are carefully evaluated, because a large city houses a large number of financial institutions, with an increased rate of assets.

Of course, Japanese banks of all sizes have problems, but Mr. Tsuchida assured his listeners that these problems can all be resolved to brighten prospects for the future. Japanese banks depend so much on hidden asset holdings. And - by 1992 - the 8% capital ratio, as agreed by member nations of the BIS, must be fulfilled.

At the end of March 1991, the capital ratio at most of Japan's 21 city banks already surpassed 8%. And all Japanese banks have cleared the 7.25% level.

By comparison, at the end of March, the Japanese stock market had declined - even though it is higher than at the end of September 1990.

Every bank in Japan is trying to suppress the growth of so-called risk assets under BIS regulations, as substantiated by statistics.

The attempt by Japanese banks to suppress the growth of assets is producing a larger problem: negative impact on the economic activity of the society.

So far, though, they have been collecting assets and trying to raise a small margin of revenues in the overseas, capital, and securities markets. Further streamlining of these operations is making it easier for them to suppress the growth of assets.

Of course, Mr. Tsuchida underscored, "it is all the better if their margins can be widened, as most financial institutions are aggressively trying to do."

The credit crunch on the Japanese scene has prevented people from talking openly about the shortage of credit. It has nothing to do with BIS regulations.

Real Estate Loans Halted

Credit is short because bank lending for real estate has been frozen. How long will those restrictions continue?

They were implemented originally to suppress the rising land prices in Japan. So it all depends on how one evaluates the present situation of land price. The latest topical issue is whether bank lending to nonbanks and the real estate sector has been fixed or frozen.

In an unprecedented manner, many companies in the Japanese real estate industry have failed. In addition to bank lending, nonbanks have also extended large loans to the real estate sector; lately, the ministry has begun collecting statistics on this subjct to help determine its policy guidelines.

For the past several years the Ministry of Finance has sought a comprehensive review of Japan's financial system that would cover all types of banking institutions. Along with commercial banks, it will include long-term credit banks, agricultural banks, workers' banks - even nonbanks and insurance companies.

Securities Conflict

The ministry has sought to adjust a very stressful relationship between securities and banking. For the past several decades, Japan's financial institutions have wanted to get into the securities business.

About 10 years ago, so-called "window guidance" legislation was introduced in Japan to authorize the activities and behavior of financial institutions. That legislation caused many people to make a fuss.

A primary issue was the concern that the new approach would cause market placements to be private rather than public.

Another issue created by the revised regulations made it impossible for the securitized products of foreign countries to be introduced in Japan. The ministry had a hard time explaining this to its international friends and, so far, has been unable to remedy this situation.

Mr. Tsuchida underscored three positive points about Japanese financial circles:

* Order has been maintained superbly in Japan. Individuals and corporations don't have to worry so much about which financial institutions they have to select for their banking needs.

* Japan has abundant assets, as well as a high savings rate. This is due to our excellent financial system, which works in favor of both the government and society. People trust Japanese institutions to hold their assets.

Fortunately, the underground - money-laundering or dealings with racketeers - still accounts for only a small portion of the Japanese economy. And Japan promises to stand tall and do everything possible to counter the underground.

* Japan has world-class, first-rate banks, securities houses, and insurance companies.

In Japan, banking must be more than just a profit-making business. People must believe that their banks perform a public service. When large banks were recently involved in scandal and charged with criminal offenses, the Japanese people were greatly saddened.

The people of Japan look at banks much differently than they look at ordinary companies, when it comes to criminal offenses.

Judging from the tone of recent deliberations at the national Diet, it seems that the Japanese people are not asking for further liberalization. They are grieving over the scandal and demoralization of financial institutions. The general public will not find it easy to accept any further liberalization or reform of banking.

"For the immediate future," Mr. Tsuchida said, "our biggest challenge is to gain public support for reform of the financial system."

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